Introduction
Jensen's measure, also known as Jensen's alpha or the Jensen index, is a financial metric used to evaluate the performance of an investment portfolio or an individual security relative to its expected return, given its level of systematic risk (beta). It is named after Michael C. Jensen, an American economist and finance professor who developed the measure in the 1960s.
The concept behind Jensen's measure is based on the Capital Asset Pricing Model (CAPM), which relates an asset's expected return to its beta. The CAPM suggests that a well-diversified portfolio's expected return should be equal to the risk-free rate (such as the yield on government bonds) plus a risk premium based on the portfolio's beta.
Calculation
Jensen's measure is calculated using the following formula:
Jensen's Alpha = Portfolio's Actual Return - [Risk-Free Rate + Portfolio's Beta * (Market Return - Risk-Free Rate)]
In this formula:
- Portfolio's Actual Return: The actual return achieved by the investment portfolio or security during the evaluation period.
- Risk-Free Rate: The return on a risk-free asset, typically represented by government bonds, which is considered to have no default risk.
- Portfolio's Beta: A measure of the portfolio's sensitivity to market movements. A beta of 1 indicates the portfolio moves in line with the market, while a beta greater than 1 suggests the portfolio is more volatile than the market, and a beta less than 1 indicates lower volatility.
- Market Return: The return of the overall market during the evaluation period, often represented by a market index like the S&P 500.
Use Cases
Jensen's alpha helps assess whether the portfolio's or security's return is superior or inferior to what would be expected based on its beta and the overall market's performance. A positive alpha indicates that the portfolio or security outperformed its expected return given its level of risk (beta), while a negative alpha suggests underperformance.
In Summary
Jensen's alpha is one of several performance measures used by investors and analysts to evaluate investment strategies and the skills of portfolio managers. However, like any performance measure, it has its limitations, and it's essential to consider other factors and metrics when assessing the overall performance of an investment.
