What does Jensen’s measure mean?
Jensen’s measure, also called Jensen’s alpha, is a way to look at the average return on an investment or portfolio that is above or below what the capital asset pricing model (CAPM) says it will be based on the average market return and the beta of the investment or portfolio. A more straightforward name for this measure is “alpha.”
How to Understand Jensen’s Measure
An investor needs to look at a portfolio’s general return and risk to get a good idea of how well an investment manager is doing. They need to see if the return on the investment is greater than the risk it takes. For instance, if both mutual funds have a 12% return, an intelligent trader would choose the fund with the lower risk. One way to tell if a portfolio is getting the proper return for its risk is to use Jensen’s measure.
If the number is positive, the portfolio makes more money than it should. Jensen’s alpha has a good number when it means that a fund manager has “beat the market” with their stock picks.
Jensen’s Measure in the Real World
To find Jensen’s alpha, we use the following four factors, assuming that the CAPM is correct:
With these factors, here is the solution for Jensen’s alpha:
Alpha = R(i) – (R(f) + B x (R(m) – R(f)))
Where
- R (i) is the return on the investment or property earned.
- R(m) = the actual return of the right market index
- R(f) is the rate of return that doesn’t involve risk for the given period.
- B is the correlation between the financial portfolio and the chosen market measure.
Let’s say, for example, that a mutual fund earned 15% last year. The right market average for this fund gave a return of 12%. That same index is the fund’s beta, which is 1.2. The risk-free rate is 3%. Here’s how to figure out the fund’s alpha:
This means that 15% – (3% + 1.2 x (12% – 3%)) = 15% – 13.8% = 1.2%.
According to the beta, the mutual fund is likelier to lose money than the average, so it should earn more. In this case, a positive alpha means that the mutual fund manager made more than enough in return to cover the risk they took over the year. The alpha would be -0.8% if the mutual fund only gave back 13%. If the alpha were negative, the mutual fund manager would not have made enough money for the risk they were taking.
Take a look at EMH.
Many people who disagree with Jensen’s measure believe in Eugene Fama’s “efficient market hypothesis” (EMH), which says that any portfolio manager’s higher results are due to luck or random chance, not skill. The theory says the market is “efficient” and correctly priced because it has already considered all the available information. This means that no active manager can add anything new to the table. To back up the idea even more, many active managers fail, just like many managers who put their clients’ money in passive index funds.
Conclusion
- Jensen’s measure is the difference between how much a person returns and how much the market returns.
- Alpha is another name for Jensen’s measure. When managers beat the market while taking on risk, they have “delivered alpha” to their clients.
- This number shows the rate of return with no risk for that period.
