Jensen’s measure,Jensen’s alpha, capital asset pricing model.
Developed by American economist Michael Jensen in 1968, the model is used to monitor the performance of mutual fund managers on a risk-adjusted basis.
Numerous studies from the inception of this performance metric to today have shown that most fund managers fail to beat the returns offered by the market (market returns can be captured by investing in benchmark indices, for example). In fact, recent studies infer that even top performing managers are not able to consistently outperform the market, and are rather highly rated based on their ability to beat other managers.
Jensen’s measure measures a fund manager’s performance against the returns that could have been expected from a market-related investment – while adjusting for the fund’s correlation to that market.
In short, Jensen’s alpha tries to explain whether an investment has performed better or worse than its beta value would suggest.
Jensen’s measure can be written as:
α = Expected return from investment – RF + β(MR – RF)
RF = the risk-free rate of return (represented by ‘safe’ investments like treasury bills)
β = the beta of the investment (or volatility relative to market volatility)
MR = expected return from the market
Jensen’s alpha adjusts the return metric of a fund to account for beta-exposure risk. Beta indicates how closely an investment follows the upward and downward movements of financial markets. A beta of more than 1 means a stock or fund is more volatile than the market, which brings greater levels of risk and which implies greater losses (or gains), especially in times of severe market events.
A positive Jensen’s alpha suggests the fund manager’s stock selection skill has delivered superior risk-adjusted returns. When comparing two funds with similar beta ratios, investors prefer the one with the higher alpha since this implies greater reward at the same level of risk.
While measuring return performance, Jensen’s alpha measure takes an investment’s risk profile into account and so gives an overall picture of a portfolio or stock’s performance on a risk-adjusted basis. This helps investors to gauge the value which a fund manager adds or detracts from a portfolio, and helps in the comparison of funds.
For example, if two investments deliver the same levels of return, investors would likely opt for the more stable, less-risky option since that fund outperforms when including risk as a performance measure.
Alpha relative to the benchmark
Excess return, also known as alpha, is a measure of a fund’s under or outperformance relative to the benchmark against which it is compared.
Common benchmarks, which are used to reflect the performance of markets, include the S&P 500 Index of large US stocks and the FTSE 250 Index, among others.
Implications of Jensen’s alpha on active management
The growing belief that stock picking and active fund management fails to consistently beat the returns which can be gained from passively following the market is partly behind the rising demand for passive strategies such as exchange traded funds (ETFs).
A newer type of ETF is passive indices which have an active element to them, including smart beta indices. These investments carry lower fees than active alternatives.
While smart beta products are rules-based and should be transparent, regulators are still deciding the best way to regulate these and other proprietary index funds. In the UK, for example, the Financial Conduct Authority is working on business standards to be applied to the promotion of these and other ‘smart’ financial products.
Alpha and beta
When evaluating the risk-adjusted returns of an asset, investors usually use alpha in conjunction with beta. Alpha measures the excess return of a fund while beta gauges how volatile the fund is relative to the market. While a security with a high beta implies healthy gains in times of upside volatility, it also suggests heavy losses amid severe market events such as the recent ‘Brexit’ vote.