Jensen's Alpha

This is a risk-adjusted measure used to gauge the extent to which a manager has added value to the returns that could have been expected from a benchmark portfolio, while taking into account the fund’s sensitivity to that benchmark.

The starting value uses the benchmark’s average return in excess of a notional risk-free rate. The riskfree rate is the rate that could have been earned from investments generally considered “safe,” such as gilts or cash equivalents. The benchmark’s average return over the risk-free rate is then adjusted by multiplying it by the beta of the fund. This adjustment compensates for the fund’s sensitivity (or lack of it) to the movements in the market.

The result produced is the expected rate. This is the rate that could be expected from the fund’s return in the given market with the same degree of sensitivity to that market, where there is no active intervention from the portfolio manager.

Jensen’s alpha is therefore:

(fund return/risk-free rate ) – expected rate

Jensen’s alpha is therefore a test of whether the fund has achieved better performance than the beta would suggest. If the value is positive, it indicates an active management style with superior stockpicking ability. If the value is negative, it indicates that returns are falling short of the adjusted benchmark return.

It can be useful to investors seeking funds with low sensitivity to the market — for example, to minimize downward movements in bear conditions. If two funds have similar lower betas, then the one with the better positive Jensen’s alpha is making superior returns for the same reduced level of downside risk.

Finally, since Jensen’s alpha is calculated by reference to a fund’s beta, a strong r-squared correlation between the fund and its benchmark is important if the measure is to have any significance.

Both Jensen’s alpha and annualised Jensen’s alpha are available.