A return measure that differentiates between returns generated through active management and those which simply result from high betas during bull markets. This measure helps calculate the difference in return achieved by a hedge fund and that achieved by a benchmark portfolio that has the same market risk (beta) as the fund. Jensen’s alpha is given by the following formula:
Jensen’s alpha = fund’s return – [risk-free rate + fund’s beta × (market return – risk-free rate)]
This tool is mainly designed for evaluating an entire portfolio in situations where market risk is a targeted amount. In this sense, the fund’s beta can be represented by the standard deviation of the entire portfolio divided by the standard deviation of the market index. However, this measure is practically difficult to apply to hedge funds due to the non-comparability of a hedge fund’s risk and return to an index’s risk and return.
Jensen’s alpha is also known as Jensen’s measure
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