What is Jensen’s alpha?
In finance, Jensen’s alpha (or Jensen’s Performance Index, ex-post alpha) is used to determine the excess return on a security or portfolio of securities over the security’s theoretical expected return. The security could be of any asset class, including stocks, bonds, or derivatives. The theoretical return is predicted by the Capital Asset Pricing Model or CAPM model (pronounced “cap-m”). The CAPM model uses statistical methods to predict the return on an asset, and uses the beta as a multiplier. The measure was first used by Michael Jensen to evalulate fund managers in the 1970s. The CAPM return is called “risk adjusted” and reflects the relative riskiness of the asset, meaning that riskier assets have higher expected returns than less risky assets. When the returns are higher than even the risk-adjusted return, that asset is said to have “positive alpha” or “excess returns”. Investors are constantly seeking investments that have higher alpha.
