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Jensen’s Alpha

 

Jensen’s alpha is used to measure the performance of an investment portfolio. The higher ratio means better performance of portfolio manager. Basically, this Jensen’s ratio shows the above market portfolio return that is adjusted to the riskiness (volatility) of the portfolio. 

 

Jensen’s alpha formula


Jensen’s alpha = Return of portfolio - [Risk free rate + Beta of portfolio (Return of market – Risk free return)]

 

* Theoretically, this ratio should use expected return of the portfolio and return of the market, but in practice historical average annual return is used. 

 

Main practical problems of the ratio

The main problems of practical implementation of Jensen’s alpha are similar to problems of other investment performance ratios (just this ratio is more difficult to calculate): 

  • It is very hard to choose accurate benchmark (market risk and market return) which would exactly meet the risk of a portfolio.
  • Different asset classes are behaving differently during short period. Data period used for calculation has to be long because of this reason, which is rarely possible in practice. 
  • The return of the past does not indicate the potential return in the future.

 

Other similar ratios that are used to measure investment performance:

 

 






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