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Jensen’s Measure – Definition

Jensen’s Measure Definition

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 Jensen’s alpha.

A Little More on What is Jensen’s Measure

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 Jensen’s measure.

Furthermore, investors check how the return on a portfolio recompense the underlying risk of the portfolio by accurately analysing the portfolio’s performance. This is effectively done using the Jensen’s 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 Jensen’s Measure is;

Jensen’s 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 Jensen’s 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 Jensen’s 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 Jensen’s measure and the most prominent one is based on the assumption of Jensen’s alpha that the excess return of a portfolio manager is based on chance or luck. This assumption or believe is derived from Eugene Fama’s Efficient Market Hypothesis (EMH). Because the Jensen’s 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 Jensen’s measure largely believes that all that a portfolio manager needs to be efficient and successful is present in the market.

References for “Jensen’s Measure

 

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