What is the 'Jensen's Measure'

The Jensen's measure is a risk-adjusted performance measure that represents the average return on a portfolio or investment above or below that predicted by the capital asset pricing model (CAPM) given the portfolio's or investment's beta and the average market return. This metric is also commonly referred to as Jensen's alpha, or simply alpha.

BREAKING DOWN 'Jensen's Measure'

To accurately analyze the performance of an investment manager, an investor must look not only at the overall return of a portfolio, but also at the risk of that portfolio to see if the investment's return compensates for the risk it takes. For example, if two mutual funds both have a 12% return, a rational investor should prefer the fund that is less risky. Jensen's measure is one of the ways to determine if a portfolio is earning the proper return for its level of risk. If the value is positive, then the portfolio is earning excess returns. In other words, a positive value for Jensen's alpha means a fund manager has "beat the market" with his stock picking skills.

Jensen's Measure Calculation Example

Assuming the CAPM is correct, Jensen's alpha is calculated using the following four variables:

R(i) = the realized return of the portfolio or investment

R(m) = the realized return of the appropriate market index

R(f) = the risk-free rate of return for the time period

B = the beta of the portfolio of investment with respect to the chosen market index

Using these variables, the formula for Jensen's alpha is:

Alpha = R(i) - (R(f) + B x (R(m) - R(f)))

For example, assume a mutual fund realized a return of 15% last year. The appropriate market index for this fund returned 12%. The beta of the fund versus that same index is 1.2 and the risk-free rate is 3%. The fund's alpha is calculated as:

Alpha = 15% - (3% + 1.2 x (12% - 3%)) = 15% - 13.8% = 1.2%.

Given a beta of 1.2, the mutual fund is expected to be riskier than the index, and thus earn more. A positive alpha in this example shows that the mutual fund manager earned more than enough return to be compensated for the risk he took over the course of the year. If the mutual fund only returned 13%, the calculated alpha would be -0.8%. With a negative alpha, the mutual fund manager would not have earned enough return given the amount of risk he was taking.

  1. Alpha

    Alpha, used in finance as a measure of performance, is the excess ...
  2. Abnormal Return

    A term used to describe the returns generated by a given security ...
  3. Annualized Total Return

    Annualized total return gives the yearly return of a fund calculated ...
  4. Risk-Free Return

    Risk-free return is the theoretical return attributed to an investment ...
  5. International Beta

    Better known as "global beta", international beta is a measure ...
  6. Market Portfolio

    A theoretical bundle of investments that includes every type ...
Related Articles
  1. Financial Advisor

    A Deeper Look At Alpha

    The Jensen index helps investors compare realized returns to what should've been achieved.
  2. Investing

    Alpha and Beta for Beginners

    An in-depth look at what alpha and beta are and what they measure.
  3. Financial Advisor

    Measure Your Portfolio's Performance

    Measure the success of your investment solely on the portfolio return may leave you blindsided to the risk you are taking. Learn three ratios that will help you evaluate your investment return. ...
  4. Trading

    Bettering Your Portfolio With Alpha And Beta

    Increase your returns by creating the right balance of both these risk measures.
  5. Investing

    Pursuing Alpha In A Well-Diversified IRA

    This strategy is not as complex as some investment gurus would like you to believe.
  6. Investing

    5 Ways To Measure Mutual Fund Risk

    These statistical measurements highlight how to mitigate risk and increase rewards.
  7. Investing

    Understanding Volatility Measurements

    How do you choose a fund with an optimal risk-reward combination? We teach you about standard deviation, beta and more!
  8. Investing

    Generating Higher Returns Without Increasing Risk

    Focus on what can help you generate higher net returns without taking additional unnecessary risks.
  9. Investing

    Adding Alpha Without Adding Risk

    Learn how to generate higher returns in your portfolio while keeping the same risk profile.
  10. Investing

    Is Apple's Stock Over Valued Or Undervalued?

    Despite several drawbacks, the CAPM gives an overview of the level of return that investors should expect for bearing only systematic risk. Applying Apple, we get annual expected return of about ...
  1. What's the difference between alpha and beta?

    Alpha is a measurement of a portfolio manager's performance in relation to the overall market. Beta gauges the volatility ... Read Answer >>
  2. Is alpha the best risk measure?

    Read about some of the strengths and weaknesses of alpha, a popular risk-adjusted performance indicator based on modern portfolio ... Read Answer >>
  3. What metrics should I use to evaluate the risk return tradeoff for a mutual fund?

    Understand the key metrics used to analyze mutual funds and how investors can use each measurement to determine the risk-reward ... Read Answer >>
  4. What are the best technical indicators to complement Weighted Alpha?

    Find out how technical analysts and traders use a stock's weighted alpha to confirm momentum or select specific stocks to ... Read Answer >>
  5. How do I use Weighted Alpha to create a forex trading strategy?

    Find out how the concept of weighted alpha can be applied to currency contracts in the foreign exchange market to spot potentially ... Read Answer >>
Hot Definitions
  1. Call Option

    An agreement that gives an investor the right (but not the obligation) to buy a stock, bond, commodity, or other instrument ...
  2. Standard Deviation

    A measure of the dispersion of a set of data from its mean, calculated as the square root of the variance. The more spread ...
  3. Entrepreneur

    An entrepreneur is an individual who founds and runs a small business and assumes all the risk and reward of the venture.
  4. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
  5. Perfect Competition

    Pure or perfect competition is a theoretical market structure in which a number of criteria such as perfect information and ...
  6. Compound Interest

    Compound Interest is interest calculated on the initial principal and also on the accumulated interest of previous periods ...
Trading Center