Jensen’s Alpha in Mutual Funds

When you invest in mutual funds, understanding how to evaluate them beyond just return potential is crucial. Jensen's Alpha is one such metric that helps you gauge whether a fund manager for an actively managed fund is adding value through their investment decisions.

Unlike simple return comparisons, Jensen’s Alpha also takes into account the risk taken to earn those returns. This gives you a view of a fund and its manager’s effectiveness.

Understanding Jensen’s Alpha can help you assess whether an actively managed fund has the potential to outperform the market without taking on excessive risk. Read on to learn what Jensen’s Alpha is, how it’s calculated, and how you can use it to support fund selection.

Table of contents

• What is Jensen’s Alpha definition
• What is formula of Jensen’s Alpha
• How to Calculate Jensen’s Alpha in mutual funds
• Why Jensen’s Alpha importance
• Difference between Sharpe Ratio, Treynor Ratio, and Jensen’s Alpha - The differences.
• Jensen’s Alpha limitations

What is Jensen’s Alpha definition

Jensen’s Alpha, named after Michael Jensen, who introduced it in 1968, is a risk-adjusted performance measure that calculates the excess return a mutual fund generated over its expected return, based on the Capital Asset Pricing Model (CAPM). In simple terms, it tells you how much better or worse a fund performed compared to what it had the potential to do given its risk level.

CAPM is a model used in finance to estimate expected returns based on the risk-free rate, market return, and the fund’s beta (market sensitivity).

What is formula of Jensen’s Alpha

The formula for Jensen’s Alpha is,

Alpha = Actual portfolio return - [Risk-free rate + Portfolio beta * (Market return – Risk-free rate)]

Here,

• Actual portfolio return: The return generated by the mutual fund over a specific time period.
• Risk-free rate: The return you would expect from an absolutely risk-free investment for the same time period.
• Portfolio beta: A measure of how much the mutual fund’s returns move relative to the market. A beta of 1 means the fund moves in line with the market; more than 1 means higher sensitivity.
• Market return: The return of the overall market, often represented by a benchmark index like the Nifty 50 or BSE Sensex.

Also Read: What is a mutual fund?

How to Calculate Jensen’s Alpha in mutual funds

To calculate Jensen’s Alpha for a mutual fund, follow these steps:

1. Find the actual portfolio return: Determine the mutual fund’s return for the period you’re analysing.
2. Obtain the risk-free rate: Use the yield from government bonds or another relatively low-risk benchmark (for example, if the 10-year government bond yield is 6%, use 6%).
3. Calculate or look up the portfolio beta: This is often available on fund fact sheets or financial data platforms.
4. Determine the market return: Use the return of a relevant benchmark index for the same period.
5. Apply the formula: Plug the values into
   Alpha = Actual Portfolio Return - [Risk Free Rate + Portfolio Beta * (Market Return - Risk Free Rate)]

Suppose a mutual fund delivered a return of 15% over one year. The risk-free rate is 6%, the fund’s beta is 1.2, and the market return is 12%.
Alpha = 15% - [6% + 1.2 * (12% - 6%)]
Alpha = 15% - [6% + 1.2 * 6%]
Alpha = 15% - [6% + 7.2%]
Alpha = 15% - 13.2% = 1.8%

So, the mutual fund outperformed its expected risk-adjusted return by 1.8%, indicating positive Alpha and possibly effective active management.

Example for illustrative purposes only.

Why Jensen’s Alpha importance

Jensen’s Alpha helps you understand whether a mutual fund manager is adding value through skillful management or if the returns are simply due to market movements and risk exposure. That’s because higher risk typically means the potential for higher returns. So, in other words, it tells you – did the fund deliver better returns than the market only because it took on higher risk? Or were the returns also owing to strategic portfolio decisions?

A positive Alpha indicates outperformance after adjusting for risk, while a negative Alpha suggests underperformance.

Jensen’s Alpha can be useful when comparing funds within the same category, where the expected risk level is broadly similar. It helps you understand whether a particular fund’s higher return came from skill — or from taking on more risk than necessary.

Note: Jensen’s Alpha is a historical measure. Past outperformance does not guarantee future results. There is no assurance that the fund manager’s approach will continue to yield the same results.

Difference between Sharpe Ratio, Treynor Ratio, and Jensen’s Alpha - The differences.

Sharpe Ratio, Treynor Ratio and Jensen’s Alpha are three common and important risk-adjusted return metrics. However, they differ in focus and what they can tell us about the fund.

• Sharpe ratio measures excess return per unit of total risk (volatility).
• Treynor ratio measures excess return per unit of systematic risk (beta).
• Jensen’s Alpha measures the absolute excess return over the expected return predicted by CAPM.

Each metric provides unique insights and using them together can give a comprehensive view of a fund’s performance.

Jensen’s Alpha limitations

• It relies on the CAPM, which assumes markets are efficient and investors are rational –assumptions that may not always hold true.
• Beta is a historical measure and may not predict future risk accurately.
• Calculations can be sensitive to the chosen time period and data frequency.

Total risk includes all types of volatility, while systematic risk refers only to market-related fluctuations.

Also Read: What are mutual fund units?

Conclusion

Understanding Jensen’s Alpha can help you look beyond raw returns and assess the true value a mutual fund manager brings to your investments. While it’s an important tool, it should be used alongside other metrics and qualitative factors to make well-rounded investment decisions. By incorporating Jensen’s Alpha into your analysis, you can navigate the complexities of mutual fund performance with more clarity and align your portfolio with your financial goals.

FAQs:

What is Jensen’s Alpha in mutual funds?

Jensen’s Alpha is a risk-adjusted measure that shows how much a mutual fund outperforms or underperforms its expected return based on its risk level.

How is Jensen’s Alpha calculated?

It is calculated using the formula Alpha = Actual Portfolio Return - [Risk Free Rate + Portfolio Beta * (Market Return - Risk Free Rate)].

What does a positive or negative Jensen’s Alpha signify?

A positive Alpha means the fund outperformed its expected return, while a negative Alpha indicates underperformance.

Why is Jensen’s Alpha important for investors?

It helps investors assess whether a fund manager’s performance is due to skill or just market movements, aiding better investment decisions.

How does Jensen’s Alpha compare to other performance metrics like the Sharpe and Treynor ratios?

Jensen’s Alpha measures absolute excess return, while Sharpe and Treynor ratios measure returns relative to total risk and systematic risk, respectively.

What are the limitations of using Jensen’s Alpha?

It depends on CAPM assumptions, uses historical beta, and doesn’t consider other risk factors, which can limit its accuracy.

Past performance may or may not be sustained in future.