Jensen’s alpha measures how much return on stocks a portfolio manager generates over time. The coefficient Jensen’s Alpha measures the difference between the returns of a portfolio and the returns predicted by the capital asset pricing model (CAPM), adjusted by the Beta of the portfolio. In other words, we can say that any value greater than zero demonstrates that a portfolio has yielded higher returns than predicted, given its market risk. To calculate this figure, we should first calculate the expected return for the given beta. Let’s say we want to determine how much return we would expect from our portfolio if it had the same beta as Apple Inc (AAPL). The beta for AAPL is 1.28 and can be found on data providers such as Yahoo Finance. After calculating our expected return for AAPL, we should compare it with actual returns from our portfolio over some period of time. If our returns exceed expectations, our Jensen’s alpha is positive; otherwise, it will be negative.

What is Jensen’s alpha?

Jensen’s alpha measures the risk-adjusted return on stocks that a portfolio manager has chosen. It can be used to evaluate how well an investment strategy has performed over time, relative to how it would be expected to perform based on the average stock market return.

In other words, Jensen’s alpha is a measure of risk-adjusted return. It’s calculated by comparing the returns of a portfolio with the returns predicted by the capital asset pricing model (CAPM). In other words, we can say that any value greater than zero demonstrates that a portfolio has yielded higher returns than predicted, given its market risk.

This metric is useful for investors and investment managers: investors use it to assess whether an investment is worth their while, while managers use Jensen’s alpha to measure their own performance against industry standards.

How to calculate Jensen’s alpha? Jensen’s alpha calculation example

The formula for calculating Jensen’s alpha is:

JA = PR - (\frac {RFR}{PB} \times (MRR - RFR))

Where PR is the portfolio’s return, RFR is the risk-free rate, PB is the portfolio’s beta and MRR is the market rate of return.

Why is it essential to understand Jensen’s alpha?

After calculating our expected return for AAPL, we should compare it with actual returns from our portfolio over some period of time. If returns exceed expectations (or Jensen’s alpha is positive), our investment was good because it produced higher returns than the market. If returns are below expectations (or negative), our portfolio underperformed the market and probably lost money.

Jensen’s alpha is the difference between a portfolio’s actual returns and those predicted by the Capital Asset Pricing Model (CAPM), adjusted for the portfolio’s Beta. In other words, it measures how much better or worse than expected your return has been.

If our returns exceed expectations, our Jensen’s alpha is positive; otherwise, it will be negative.

FAQ

Is Jensen’s alpha negative?

Negative alpha indicates that the portfolio has not earned its required return.

Who developed Jensen’s alpha?

Jensen’s alpha (α) was introduced by Jensen (1967, 1969).

Is Jensen’s alpha the intercept?

Jensen’s alpha is the intercept of the regression equation in the Capital Asset Pricing Model and is in effect the excess return adjusted for systematic risk.