Jensen's alpha is a performance measure developed by Michael Jensen. It represents the average return on a portfolio over and above that predicted by the Capital Asset Pricing Model (CAPM), given the portfolio's beta and the average market return. This metric is used to determine the excess return that a portfolio generates due to active management, as opposed to market movements.
Jensen's alpha is calculated by taking the portfolio's return and subtracting the expected return, as given by the CAPM. A positive Jensen's alpha indicates that the portfolio has outperformed its benchmark after adjusting for market risk, suggesting effective management. A negative alpha indicates underperformance. This measure is particularly valued in evaluating the skill of fund managers and the effectiveness of active portfolio management strategies.
While Jensen's alpha is a useful tool for assessing performance, it has limitations. It's based on historical data and assumes market efficiency and a constant beta, which may not hold true in all market conditions. Additionally, it does not account for the impact of trading costs or taxes. Investors should therefore use Jensen's alpha in conjunction with other metrics and qualitative assessments when evaluating portfolio performance.
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