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Jensen’s Alpha

Jensen’s Alpha. First used as a measure in the evaluation of mutual fund managers by Michael Jensen in 1968. Idea: Measure should adapt to volatility of the stock’s price. Formal statement of CAPM. Expected return on an asset related to Beta:. Where E() = “expected”

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Jensen’s Alpha

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  1. Jensen’s Alpha First used as a measure in the evaluation of mutual fund managers by Michael Jensen in 1968. Idea: Measure should adapt to volatility of the stock’s price.

  2. Formal statement of CAPM Expected return on an asset related to Beta: Where E() = “expected” Ri = return on investment Rm = market return Rf = risk free rate Bi = beta of the asset or portfolio

  3. Graphical statement of CAPM

  4. Move from “expected” to “actual” Consider now actual returns Ri = Rf + Bi*(Rm-Rf) It doesn’t usually add up exactly.

  5. Example: SPLV versus SPY SPLV’s beta = 0.75 Return should be lower

  6. We need an extra term to make it add up Ri = Rf + Bi*(Rm-Rf) + alpha CAPM asserts that E(alpha) = 0 Others assert that alpha is a measure of management skill.

  7. Another view of Alpha & Beta

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