What is Jensen's Measure?

Jensen's measure is a statistical measurement of the portion of a security's or portfolio's return that is not explained by the market or the security's relationship to the market but rather by the skill of the investor or portfolio manager. It is also called alpha.

How Does Jensen's Measure Work?

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:

r = Rf + beta x (Rm - Rf ) + Jensen's measure (alpha)

r = the security's or portfolio's return
Rf = the risk-free rate of return
beta = the security's or portfolio's price volatility relative to the overall market
Rm = the market return

The bulk of the CAPM formula (everything but the alpha factor) 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 stocks should return 12%, but it actually returns 15%, we would call the 3% difference (the 'excess return') 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 Does Jensen's Measure Matter?

Jensen's measure is a measurable way to determine whether a manager has added value to a portfolio, because alpha is the return attributable to the skill of the portfolio manager rather than the general market 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 support 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.