What is Jensen's Alpha in Mutual Funds?

Jensen's alpha is a metric used by investors to evaluate the performance of actively managed mutual funds. It measures the fund's return compared to the return predicted by its risk level, quantifying the value added or lost by the fund manager. This risk-adjusted view of performance allows investors to judge a fund manager's skill in stock selection and market timing. In a world with a variety of mutual fund choices, Jensen's alpha gives investors a way to cut through the noise and identify funds where active management has truly added value.

Definition of Jensen's Alpha

Also known as Jensen's measure, it evaluates a fund's performance compared to its expected performance based on its level of risk. It was created by Michael C. Jensen in 1968 as a way to determine if a fund manager has skill in selecting investments that outperform the market.

The Jensen's alpha formula is

Jensen's Alpha = Portfolio Return - [Risk-Free Rate + Portfolio Beta * (Market Return - Risk-Free Rate)]

Where,

• Fund Return is the actual return of the mutual fund over a period of time. This is calculated by taking the change in price over the time period plus any dividends paid, divided by the initial price.

• Risk Free Rate of Return is the return that could be earned by investing in a risk-free asset over the same time period as the fund return. This is often measured by the return on short-term government bonds.

• Beta of the Fund measures the fund's volatility in relation to the overall market. A beta above 1 indicates the fund is more volatile than the market. A beta below 1 indicates the fund is less volatile.

• Market Return is the return of the overall market or benchmark over the same time period as the fund return.

• (Beta of the Fund) * (Market Return - Risk Free Rate of Return) represents the expected return of the fund based on its beta and the market performance.

Interpreting Jensen's Alpha

Jensen's alpha shows by how much the fund outperformed or underperformed its expected return based on its risk level. A positive alpha indicates the fund manager was able to add value and achieve returns above the performance predicted by the fund's beta. A negative alpha means the fund underperformed compared to expectations.

An alpha of zero means the fund's return was in line with the return predicted by its beta. In this case, the fund manager did not add or subtract any value compared to a passive index fund with a similar risk profile.

Key Considerations for Use of Jensen's Alpha

• It requires a benchmark index to represent the 'market return' to compare the fund against. Often this is a broad stock market index like the S&P 500.

• It evaluates funds on a risk-adjusted basis. Outperformance due to taking more risk is accounted for by the beta term. True skill is measured by higher returns beyond what the added risk would predict.

• It is calculated over a specific time period, often 3-5 years. Looking at alpha over longer time periods gives a better view of a manager's skill.

• Comparing a fund's alpha to other funds in its category accounts for differences in risk levels between categories. A high alpha in a low-risk bond fund category represents more skill than the same alpha in a high-risk stock fund category.

• Jensen's alpha only considers market risk measured by beta. It does not account for other factors like interest rate risk, credit risk, liquidity risk, etc.

• A high alpha does not necessarily mean positive absolute returns. A fund can lose money but still have a positive alpha if it lost less than its beta predicted.

Evaluating Funds Based on Jensen's Alpha

When evaluating mutual funds based on Jensen's alpha, investors should consider the below points:

• Consistency - Does the fund manager consistently generate positive alphas over time? Occasional high alphas may be due to luck rather than skill.

• Statistical significance - Is the alpha high enough compared to the fund's volatility to represent true added value with 95% confidence?

• Costs - High fees can offset gains from skilled investing. Alpha should be evaluated net of all expenses.

• Manager tenure - Has the manager demonstrating skill been at the helm long enough to judge their alpha generation ability? New managers may compile short-term unsustainable alpha results.

• Investment style - Different styles can have higher or lower alpha opportunities. Comparing a fund's alpha against its style peers puts the results in better context.

• Benchmark choice - Using an inappropriate benchmark to represent 'market return' will skew alpha calculation higher or lower. Benchmark choice can also improperly reflect fund risk.

Thus, Jensen's alpha is a metric that mutual fund investors can use to evaluate returns on a risk-adjusted basis. It quantifies the value a fund manager adds compared to simply holding the market portfolio. A high positive alpha over long time periods demonstrates the manager's skill in actively selecting investments that outperform the market. But investors should consider alpha generation consistency, statistical significance, costs, manager tenure, style, and benchmark fit when judging a fund by its alpha. Used appropriately, Jensen's alpha provides valuable information on a key aspect of mutual fund performance for investors.