Jensen's Measure - Explained
What is Jensen's Measure?
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What is Jensen's Measure?
A return on an investment or a portfolio that supersedes or is below the anticipated return on the portfolio or investment can be measured using the Jensen's Measure. The Jensen's Measure statistically measures the return on a portfolio that is more than or less than the expected return outlined by the capital asset pricing model (CAPM). The appropriate rate of return of an asset are predicted and given by CAPM. There are however some investments of portfolios that have rates of returns surpassing the average market return or below the average return. The Jensen's Measure is also called alpha of Jensens alpha.
How Does Jensen's Measure Work?
The Jensen's Measure is a performance measure that evaluates the performance of an investment manager using the average return on the portfolio or investment. The level of variance of the return on a portfolio from the average rate of return or investment's beta is measured using the Jensens measure. Furthermore, investors check how the return on a portfolio recompense the underlying risk of the portfolio by accurately analysing the portfolios performance. This is effectively done using the Jensens measure. In most cases, investors opt for portfolios with less risks and good rate of return. The capital asset pricing model (CAPM) helps in calculating the expected level of risk and rate of return on an investment or portfolio. The formula for calculating Jensens Measure is; Jensens Alpha= R(i) - (R(f) + B x (R(m) - R(f))) It is however important to know that the above formula is used when the CAPM is assumed correct. The underlying variables in the formula above are; The realized return of the portfolio or investment = R(i) The realized return of the expected market index = R(m) The risk-free rate of return for the period of time = R(f) The beta of the portfolio of investment in line with the chosen market index = B Below is an illustration to enhance a better understanding of the Jensens Alpha; If the realized return of a fund in 2015 is 17% while the expected market index for the same fund is 14%. If the risk-free rate of the fund is 4% and its beta is 1.4. The Jensens formula will be used in calculating it. R(i) - (R(f) + B x (R(m) - R(f))) 17% - (4% + 1.4 x (13% - 4%)). The result of this calculation will be helpful in determining the return on the portfolio based on its beta and expected market return. There are certain drawbacks on the Jensens measure and the most prominent one is based on the assumption of Jensens alpha that the excess return of a portfolio manager is based on chance or luck. This assumption or believe is derived from Eugene Famas Efficient Market Hypothesis (EMH). Because the Jensens measure placed more importance on luck or chance than the skills and competence of a portfolio manager, it has given rise to many controversies. The Jensens measure largely believes that all that a portfolio manager needs to be efficient and successful is present in the market.