Jensen's Measure definition implies a type of performance measure that is risk-adjusted. The given measure helps in representing the average returns on the given investment or Portfolio –above or below the predicted value by the CAPM (Capital Asset Pricing Model).
The only condition here is that the Beta of the portfolio or the investment along with the average Market return should be provided. The given metric is also commonly known as Alpha.
For accurately analyzing the overall performance of the investment manager, the respective investor should not just look into the portfolio’s return. At the same time, the investor should also consider the risk of the given portfolio for observing whether or not the return of the investment would compensate for the risk being undertaken. For instance, if there are two Mutual Funds having a 12 percent return, a wise investor should aim at going for the option of the fund that is less risky. Jensen's Measure serves to be one of the effective ways when it comes to determining whether or not a particular portfolio is earning the right returns for the given level of risk.
If the given value turns out to be positive, then the particular portfolio is earning excess returns. Therefore, it can be said that the positive value for Jensen’s Alpha would imply that the fund manager is capable of “beating the market” with the respective stock-picking skills.
Upon the assumption that CAPM tends to be correct, Jensen's Measure can be calculated by making use of the following formula:
Alpha = R (i) –(R(f) + B X (R(m) –R(f)))
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At the same time, B refers to Beta of the investment portfolio as per the given market index.
For instance, let us assume that a particular mutual fund realized 15 percent return during last year. The right market index for the given fund was responsible for returning 12 percent. The Beta for the given index is 1.2, and value for the risk-free rate turns out to be 3 percent. Then, Alpha can be measured as:
Alpha = 1.2 percent
As per the value of beta at 1.2, the given mutual fund will be considered as riskier in comparison to the index, while earning more at the same time. The positive value of Alpha indicates that the respective mutual fund manager is earning more than the required return for compensating for the given risk they might have taken some years back. The negative value of Alpha will indicate that the mutual fund manager might not have earned an ample return for the respective amount of risk taken by them.
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