Your Money: How Jensen’s alpha finds correct funds

Use it to compare funds with different returns but same risk

Assessing a mutual fund’s performance in terms of its returns usually takes the form of comparing it against the performances of other similar funds. If the other funds are underperforming, this method will yield a false picture to the investor.

Jensen’s alpha is one of the important standard performance measures that tell us what the intrinsic performance of a fund is.

Understanding alpha

Before we learn what Jensen’s Alpha is all about, let us first understand the term ‘alpha’. Alpha is a performance measure that tells us how much additional returns a fund is yielding compared to the market in general. The concept of alpha began when weighted average index funds were first created to replicate the market. Investors could earn market returns simply by investing in such index funds. Gradually, investors began to expect returns in excess of what index funds delivered.

This gave rise to a new performance measure called alpha to track the excess of returns a fund could generate by active investment strategies compared to a passively managed fund like index fund.

To illustrate, if the alpha of a large-cap fund with benchmark index S&P BSE LargeCap is 2, then it means it has generated 2% more returns than the S&P BSE LargeCap index. Similarly, if a banking sectoral fund with benchmark index NIFTY Bank has alpha of -3, then it has generated 3% lesser returns than the NIFTY Bank index.

What is Jensen’s Alpha

If two funds achieve the same returns, then the investor should know which fund involves lesser risk and invest in that. Jensen’s alpha is a risk-adjusted performance measure of returns that helps us determine this. It is given by the formula:

Jensen’s alpha = Ri – [ Rf + B x ( Rm – Rf ) ]

Where Ri = Actual returns of the fund or investment

Rm = Actual returns of the benchmark index (market)

Rf = Risk-free rate of return

B = Beta of the fund with respect to its benchmark index

Jensen’s alpha helps us determine if a fund or investment has compensated adequately through the returns generated for the level of risk undertaken by the investor.

An illustration

To illustrate, let us say fund A (Beta of 1.1) generated returns of 12% for a certain period while its benchmark index generated 11%. Let us say fund B (Beta of 1.3) also generated returns of 12% for the same period while its benchmark index generated 11%. Assume the risk-free rate of return is 4%.

On the face of it, both funds generated equal returns so the investor may accidentally invest in the wrong fund if risk is not taken into account. Jensen’s alpha helps us determine the correct fund to invest in.

Jensen’s alpha of fund A = 12% – [ 4% + 1.1 x ( 11% – 4% ) ] = +0.3%

Jensen’s alpha of fund B = 12% – [ 4% + 1.3 x ( 11% – 4% ) ] = –1.1%

As evident, fund A with a positive alpha is a better choice as it has more than compensated with returns for the risk taken, whereas fund B actually has underperformed by not justifying the higher risk taken with higher returns since its alpha is negative.

If the investor had calculated alpha directly, he would have found that both funds had generated excess returns of 1% over that of their benchmark indices, so both funds would have looked equally attractive. Jensen’s alpha can be used to compare funds with different returns but same risk, or same returns but different benchmark returns, or any combination thereof. It’s a powerful tool to assess returns of a fund or investment.

Most of the information required for calculating Jensen’s alpha are available in the Key Information Memorandum and Fund Factsheet of the fund, or in the public domain. Investors are advised to study these carefully and invest.

This article was originally published in The Financial Express