Jensen's Measure (Alpha) 🌟🖋️

While Sharpe and Treynor give you a "Ratio," Michael Jensen developed a measure that gives you a single percentage number: Alpha. It tells you exactly how much extra return (in %) a manager has created through their skill.

1. The Jensen Equation

Jensen's Alpha is the difference between the actual return of a portfolio and the return it should have made according to the CAPM.

Alpha = Rp - [ Rf + Beta_p * (Rm - Rf) ]

Where:

• Rp: Actual portfolio return.
• [ Rf + Bp * (Rm - Rf) ]: This is the CAPM "Benchmark" return.

2. Interpreting Alpha

• Positive Alpha (> 0): The manager has "Beaten the Market." They have provided a return higher than what was expected for their risk level. Excellent performance.
• Zero Alpha (= 0): The manager performed exactly as expected for their risk level. They are essentially an index fund.
• Negative Alpha (< 0): The manager destroyed value. They did worse than a simple mix of stocks and bonds would have done.

3. Why Alpha is the "Holy Grail"

Investment professionals are constantly searching for Alpha. Why?

• Beta is easy to get (just buy an index fund).
• Alpha is hard to get. It requires superior research, better timing, or unique insights.
• If a manager has a positive Alpha, they are worth their fee. If they have zero or negative Alpha, you should fire them!

Summary

• Jensen's Alpha measures the manager's ability to "beat the CAPM."
• It is a pure measure of Stock-Picking Skill.
• A positive Alpha is the sign of a star fund manager.
• It is widely used in selecting "Active" mutual funds.

Quiz Time! 🎯

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