What Is Jensen's Measure?

What Is Jensen's Measure?

Let me explain Jensen's alpha to you—it's a key measure in finance that evaluates how an investment portfolio performs compared to a benchmark index. It figures out the excess return the portfolio generates beyond what's expected from the capital asset pricing model (CAPM). People often just call this alpha. In simple terms, it shows you the abnormal or extra returns of an investment versus its predicted returns.

You can apply Jensen's measure to any asset, like stocks, bonds, or even whole portfolios. It factors in the beta and the average market return for that investment or portfolio.

Key Takeaways

Jensen's measure boils down to the difference between what an investment manager returns and what the overall market does. It's often called alpha, so if a manager beats the market while matching the risk level, they've delivered alpha to their clients. Importantly, it includes the risk-free rate of return for the period in its calculation.

Formula and Calculation of Jensen's Measure

Assuming the CAPM holds true, you calculate Jensen's measure with these four variables: Alpha = R(i) - (R(f) + B x (R(m) - R(f))). Here, R(i) is the realized return of the portfolio or investment, R(m) is the realized return of the market index, R(f) is the risk-free rate, and B is the beta of the portfolio against that index.

When you plug in the numbers, you get one of three results. A positive alpha means the asset is outperforming the market or benchmark. A negative one shows underperformance. If it's zero, the investment is neutral, tracking the market consistently.

Understanding Jensen's Measure

Economist Michael Jensen came up with this measure in 1968 to evaluate investment returns with risk in mind. As I mentioned, it's a risk-adjusted performance metric. You or any investor can use the formula to find the excess returns over what's expected from CAPM, which models an investment's expected return by considering risk and the time value of money.

This measure also helps analyze an investment manager's performance. Look at the portfolio's overall return and its risk level to see if the return justifies the risk. For instance, if two mutual funds both return 12%, you'd pick the less risky one. Jensen's measure tells you if the portfolio earns the right return for its risk—if positive, it's generating excess returns, meaning the manager is beating the market through skill.

Criticism of Jensen's Measure

Critics of Jensen's measure often subscribe to the efficient market hypothesis (EMH), developed by Eugene Fama. EMH says an asset's price reflects its fair value, including all risks and information. Followers believe you can't consistently beat the market, so any excess returns come from luck, not skill. The market is efficient and accurately priced, and evidence shows many active managers don't outperform passive index funds.

Example of Jensen's Measure

Consider this example: suppose a mutual fund returned 15% last year, while its market index returned 12%. The fund's beta is 1.2, and the risk-free rate is 3%. The alpha calculates to 15% - (3% + 1.2 x (12% - 3%)) = 15% - 13.8% = 1.2%. With a beta of 1.2, the fund is riskier than the index and should earn more—a positive alpha means the manager earned enough to cover that risk. If it only returned 13%, alpha would be -0.8%, indicating insufficient return for the risk.

Does Jensen's Alpha Mean the Same As Jensen's Measure?

Yes, Jensen's alpha and Jensen's measure refer to the same thing. It's a metric comparing an investment or portfolio to the market, adjusted for risk.

What Does Alpha Mean in Finance?

Alpha measures performance, specifically how well a security outperforms the market. Returns are compared to a benchmark index, so alpha is the excess return over that benchmark. High alpha is desirable as it shows better excess returns.

What's the Difference Between Alpha and Beta?

Alpha and beta are distinct metrics. Alpha shows if an asset outperforms the market, while beta measures the volatility of a security's price relative to the market.

The Bottom Line

Investing involves risks and rewards, and tools like Jensen's measure can guide you by revealing excess returns adjusted for risk. Remember, it's not infallible, so always do your research before deciding.