Jensen’s Alpha, also known as Jensen’s measurement, Jensen’s performance index and ex-post alpha, is a measurement of abnormal return from a portfolio or security. It is named after its developer, Michael Jensen. Jensen’s alpha indicator was first used in the 1970s to evaluate the performance of mutual funds in relation to a benchmark or expected performance. For a better awareness read what is Alpha Indicator.
Jensen’s alpha is a modification of the traditional alpha indicator and it also considers risk free rates. The modified formula is,
Where Alpha p is Jensen’s Alpha, rp is the average portfolio return expected, rf is the risk free rate, Beta p is the beta of the portfolio and rM is the expected market return or benchmark return.
The basic idea behind Jensen’s performance index is that when measuring a portfolio performance, one should also consider the risk of the portfolio in addition to the risk. For example if two mutual funds have the same return, the one with lower risk will be the better one to invest in.
Jensen’s alpha is interpreted just as the alpha indicator. Positive values indicate that the portfolio is earning excess returns than benchmark, and negative values indicate that it is earning lower than the benchmark.
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