The financial world is facing a huge crisis at the moment. The world is ceasing to recover after the COVID-19 crisis and it’s a colossal mess when it comes to the financial markets but, however, a lot of investors are seeing this as an opportunity to invest their money. According to them, it might be a risky investment but can reap enormous benefits if it pays off the way they’re seeing it.
Risk plays an important role in the financial atmosphere. May it be an individual or a financial institution, the risk is a crucial factor for all of them. It can either bring them huge profits or tear them apart, so calculating the risk is a very important thing one has to take into account in order to be successful in the financial scenario. Here’s where Jensen’s Alpha comes into the picture. Want to know more? Let’s find out!
In this article we’re going to learn about what is Jensen’s Alpha, how it works, why do we need to use Jensen’s Alpha, and also what limitations are there when using Jensen’s Alpha. Knowing this concept would act super crucial for understanding the real and potential depth of the investment portfolios. Further, this would enable you to understand how you can comprehend and calculation this miracle concept value, and thus helping yourself and others around with the benevolence of the same.
So without wasting further time, let’s start!
What is Jensen’s Alpha?
A Jensen’s alpha (also known as Jensen’s performance index or ex-post alpha) is a tool that is used to determine an abnormal return or a portfolio or security over an expected return so basically, it measures the real performance over a calculated return. It can be any kind of an asset such as a bond, stock, or a derivative. The return is calculated through a market model which is known as CAPM (Capital Asset Pricing Model).
The CAPM uses statistical methods in order to predict the suitable risk-adjusted return of an Asset. The returns are supposed to take account of the riskiness factor of a certain asset which means that it has to be ‘Risk-Adjusted’.
The Jensen’s Alpha was first used by Michael Jensen in 1968 where he wanted to evaluate the mutual fund managers. He wanted to know more about the emerging markets and also to see whether the mutual fund managers’ returns indicated an ability to outperform the market. One of these methods would have been a very simple one where he could’ve compared the managers’ return to the market portfolio but it would have been very misleading as the risk factor hadn’t been considered. He was adamant on learning that if the managers could add value over the long term and this is how Jensen’s Alpha was born.
Jensen’s Alpha Formula represents the math equation for Alpha calculation based on the realized return of the portfolio or investment, realized a return of the appropriate market index, risk-free rate of return for the period, and a beta (systematic risk of the portfolio).
Jensen’s Alpha Formula is:
Alpha = R(portfolio) – (R(rate) + Beta x (R(index) – R(rate)))
R(portfolio) = the realized return of the portfolio or investment
R(index) = the realized return of the appropriate market index
R(rate) = the risk-free rate of return for the period
Beta = the beta of the portfolio of investment concerning the chosen market index
How does Jensen’s Alpha work?
So the formula involving Jensen’s Alpha is used to calculate the difference between a return that an asset provides and the theoretically calculated expected return. The formula can be applied to all kinds of assets such as a stock, bond, derivatives, etc. the expected return, in this case, is calculated using CAPM (Capital Asset Pricing Model), a model that can, on the basis of average market return, interest rate and the multiplier, calculate the expected rate of return.
The simple formula which is used to calculate this is as follows:
Portfolio Return-[Risk Free Rate+portfolio beta x (market return-risk free rate)]
The beta multiplier represents the asset’s uncertainty as compared to market factors. The Alpha represents the returns that are generated in excess over the calculated return. A positive alpha indicates better performance whereas a negative alpha indicates poor performance.
If an Asset’s return is, even more, higher than the risk-adjusted or the predicted return, it is known as a positive alpha or an abnormal return. This basically means that the fund manager has the skills to beat the market. A negative alpha indicates that the fund has performed poorly or has provided returns that were lower than expected.
Why is it important?
Every individual or a fund manager invests in the market for a sole purpose which is a profit. For this, they should be aware of the risks that they’ll have to take while investing in a stock or a bond, or any other asset. This is where Jensen’s alpha comes into the picture which provides them a properly calculated measure of what they’re going to get out of that asset against the risk involved in it. The main challenge that a fund manager faces is that they need to go for securities that offer maximum returns with a minimum risk factor. Jensen’s Alpha helps them to achieve this.
So, for example, if there are two schemes offering a similar kind of return, the investor can go for the one which would be more lucrative for an investor that is, the one which offers the same return with a lesser amount of risk. Jensen’s Alpha helps the investor to determine whether the returns an asset is offering acceptable when compared to the risk which is applicable.
Limitations to Jensen’s Alpha:
An Alpha aims to generate returns that are not in line with market performance. According to statistics, a fund that is generating higher yields is unlikely to do so at a later stage as their prices fluctuate according to the performance and adjust accordingly to reflect their value.
Jensen’s Alpha, indeed, is a great tool when it comes to measuring the performance of a certain stock and also, helps the fund managers to maximize the individual’s or the company’s risk to return ratio. So, you can also use the same to your advantage in order to measure your fund’s performance and increase your profitability and decrease risks.
So that was our take on Jensen’s Alpha! But do not just go with our word, investments are a crucial element of ones’ life, therefore it is essential to analyze, study and learn about them in great detail and then get to the action. So, huddle up! Research and Learn: It’s time to get investing!