Jensen's alpha (also called Jensen's measure or simply alpha in portfolio management) quantifies a portfolio manager's ability to generate returns above those predicted by the Capital Asset Pricing Model (CAPM), adjusted for the portfolio's systematic risk (beta).
Formula: > Jensen's Alpha = Portfolio Return − [Risk-free Rate + Beta × (Market Return − Risk-free Rate)]
Equivalently: Alpha = Actual Return − CAPM Expected Return
Example: - Portfolio return: 15% - Risk-free rate: 3% - Market return: 10% - Portfolio beta: 1.1 - CAPM expected: 3% + 1.1 × (10% − 3%) = 3% + 7.7% = 10.7% - Jensen's alpha = 15% − 10.7% = +4.3% (manager outperformed)
Interpretation: - Positive alpha: Manager added value beyond what could be explained by market exposure alone. - Negative alpha: Manager destroyed value on a risk-adjusted basis. - Zero alpha: Performance consistent with CAPM expectations for the risk taken.
Jensen's alpha vs. Sharpe vs. Treynor: - Sharpe and Treynor are ratios (relative measures, useful for ranking). - Jensen's alpha is an absolute excess return measure.
Limitations: Depends heavily on the choice of benchmark (market portfolio) and the accuracy of the CAPM model itself.
> Exam tip: Jensen's alpha is CAPM-based. Unlike Sharpe and Treynor (which are ratios), Jensen's alpha is an absolute number in percentage terms. A common exam question asks you to calculate all three for two portfolios and determine which performed better on a risk-adjusted basis.