What it is:
How it works (Example):
Mathematically, Jensen's measure (which was developed in 1968 by Michael Jensen) is the rate of return that exceeds what was expected or predicted by models like the capital asset pricing model (CAPM). To understand how it works, consider the CAPM formula:
The bulk of the CAPM formula (everything but the alpha ) calculates what the rate of return on a certain security or portfolio ought to be under certain market conditions. So if this portion of the model predicts that your portfolio of 10 should return 12%, but it actually returns 15%, we would the 3% difference (the " ") alpha, or Jensen's measure.
Note that two similar portfolios might carry the same amount of risk (that is, they have the same beta) but because of differences in Jensen's measure, one might generate higher returns than the other. This is a fundamental quandary for investors, who always want the highest return for the least amount of acceptable risk.
Why it Matters:
Jensen's measure is a measurable way to determine whether a manager has added value to a portfolio, becauseis the return attributable to the skill of the rather than the general conditions.
The very existence of alpha is controversial, however, because those who believe in the efficient market hypothesis (which says, among other things, that it is impossible to beat the market) believe alpha is attributable to luck rather than skill; they this idea with the fact that many active portfolio managers don't make much more for their clients than those managers who simply follow passive, indexing strategies. Thus, investors who believe managers add value accordingly expect above-market or above-benchmark returns -- that is, they expect alpha.