Given the portfolio’s or investment’s beta and the average market return, Jensen’s Alpha is a risk-adjusted performance metric representing the average return on a portfolio or investment above or below the capital asset pricing model (CAPM) predicted. Simply put, Alpha is the name given to this statistic.
Example of it:
Rp = Expected Portfolio Return
Rf = Risk-Free Rate
Bp = Beta of the Portfolio
Rm = Expected Market Return
A portfolio has realised a return of 15%. The approximate market index returned 12%. The fund’s beta versus the same index is 1.2, and the risk-free rate is 6%.
Jensen’s Alpha = 15 – [ 6 + 1.2 * (12 – 6) ] = 1.8%
Why is it vital to know Jensen’s Alpha?
As a fundamental practice of analysing our investments, investment managers are responsible for showing their performance against a given benchmark. Jensen’s Alpha is one of the known measures utilised to measure the fund’s performance.