What Is Jensen’s Alpha in Mutual Funds?

The moment you plan to invest in mutual funds, you will find hundreds of technical terms before you. Starting from TER in mutual funds to Jensen’s Alpha, all these are very important. But at the same time, understanding them is not easy. 

Considered to be highlight technical in nature, these are usually left aside. But no more. It's time to simplify these terms and help you take better investment calls. So, let us start with understanding what Jensen's Alpha is and how to use it in the guide over here. 

What Is Jensen’s Alpha?

Jensen’s Alpha in mutual funds is a performance measure. It shows whether a fund has generated returns above or below what was expected. It is based on the level of risk it took. 

It adjusts the fund’s returns against a benchmark index. Further, it shares the risk-free rate to highlight the fund manager’s true contribution.

In simple terms, it answers the question: Has the fund manager added value beyond the market returns, after accounting for risk? So, if the alpha value is positive, then yes, else no. Hence, you must know how to calculate and evaluate Jensen’s Alpha.

Jensen’s Alpha Formula

When you are considering calculating Jensen’s Alpha, you also need to know the formula. The standard formula that you would need to use is as follows:

Jensen’s Alpha = (Rp – Rf) – ? × (Rm – Rf)

Where:

• Rp = Return of the portfolio or mutual fund

• Rf = Risk-free rate of return (often government securities)

• ? (Beta) = Sensitivity of the mutual fund to market movements

• Rm = Return of the benchmark market index

This formula essentially compares the fund’s actual return with the return it should have earned given its risk (beta) and the market’s performance. The difference shows whether the fund manager’s decisions added or reduced value.

How to Calculate Jensen’s Alpha with Example

Calculating Jensen’s Alpha involves substituting the fund’s return, benchmark return, risk-free rate, and beta into the formula. So, here are the steps that you would need to follow to calculate the same:

Step 1: Start by finding the values to calculate the Jensen’s Alpha. So, here are the values that we need to consider.

• Fund return (Rp) = 14%

• Benchmark return (Rm) = 10%

• Risk-free rate (Rf) = 6%

• Fund beta (?) = 1.2

Step 2: Put the values in the following formula to get the result.

Jensen’s Alpha = (Rp – Rf) – ? × (Rm – Rf)

Step 3: Start calculating the values. This will be as follows:

Jensen’s Alpha = (14 – 6) – 1.2 × (10 – 6) = 8 – 4.8 = +3.2

Interpretation:

As per the calculation, the fund generated an additional 3.2% return as compared to the expected returns. This is considering the risk and volatility in the market. This shows that the fund has positive alpha, which means the fund manager is skillful and has ensured better performance using the skills and right decision-making.

What Does Jensen’s Alpha Measure?

Jensen’s Alpha measures the risk-adjusted performance of a mutual fund. It shows whether the fund has performed better or worse than expected after the market risk and the fund's volatility are considered. It also shares the fund manager’s skill in generating returns for the investors. 

The results can be any of the following:

Why Is Jensen’s Alpha Important for Investors?

When you are investing in a mutual fund, the first thing that you must check is the past performance and the skills of the fund manager. Whether you are planning to invest in small-cap or large-cap funds, you need to know these details.

So, here is what the Jensen’s Alpha can help you with:

• Identifies True Outperformance: Positive alpha shows if the fund beat the market after considering risk.

• Protects Against Overconfidence in Returns: If you are seeing a high return but with no positive alpha, this might be just a correction and not the manager's skill to rely on.

• Guides Smarter Choices: Investors can use alpha to compare multiple funds. This will allow them to select the right fund and ensure they gain better returns.

• Justifies Active Fund Fees: If the active fund's cost is more than index funds, then you can understand if this is worth investing.

• Improves Portfolio Strategy: Using this properly is really important. This will help you ensure that you create a portfolio that is balanced and ensures growth as well.

Limitations of Jensen’s Alpha in Mutual Funds

While Jensen’s Alpha is a useful metric, it is not perfect. There are a few limitations that you would need to know when you are using Jensen’s Alpha for mutual funds:

• Relies on past data, which may not reflect future performance.

• Results vary depending on the benchmark chosen, and the wrong benchmark can mislead.

• Market volatility or sudden economic changes can distort alpha.

• Might not show consistency as the alpha values might change over time.

• Not perfect for passive funds, as the alpha is usually almost zero.

Conclusion

Jensen’s Alpha is literally one of the most important measures that you would need to use. It allows you to evaluate the performance of the mutual fund. By using this, you can understand the fund performance in the risk-adjusted market and when there is volatility.

Also, using this, you can know the skills of the fund manager as well, which is crucial for making the investment call. While it has some limitations, when combined with other metrics, alpha becomes a powerful tool for making smarter investment choices.

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FAQs

1. Why is Jensen’s Alpha considered a risk-adjusted metric?

Yes. It factors in the fund’s beta and benchmark returns after considering the market risk and volatility. This is why it is a great metric to consider. 

2. Can two funds with similar returns have different alphas?

Yes. Even when the returns are the same, alpha can be different. It can be due to market correction or for some other reason.

3. Does Jensen’s Alpha include expense ratios?

It does. Since it is based on net returns, management fees and expenses are already accounted for in the calculation.

4. Is Jensen’s Alpha useful for SIP investors?

Yes. For long-term SIP investors, tracking alpha is important. It helps you identify the funds that have performed well and have added value over time.

5. Can Jensen’s Alpha be negative even if the fund shows a profit?

Yes. A fund may earn positive returns but still have a negative alpha if those returns are lower than what was expected given its risk.