Evaluating an investment’s return without taking into account risk provides little insight into how the security or portfolio is actually performing. Each security requires a different rate of return, which is determined based on the capital asset pricing model (CAPM). The Jensen Index, or Alpha, assists investors in determining the difference between the actual return and the required return. This article will give a more in-depth look at Alpha and its practical application.

Watching: What is Alpha

Definition of Alpha

The Jensen Index, or Alpha, is related to the capital asset pricing model (CAPM). The CAPM equation is used to determine the required rate of return for an investment, and it is often used to gauge the actual performance of a diversified portfolio. First, the model is formed assuming that this is a portfolio that is maximally diversified (that is, unsystematic risk has been eliminated). Second, since the primary source of risk for a diversified portfolio is market risk (systematic risk), beta would be an appropriate measure of risk. Defined by the CAPM model, Alpha is used to determine the difference between the actual return and the required return. Alpha is calculated according to the following formula:

α = Rp –

In there:

Rp = Realized return of portfolio

Rm = Market return

Rf = Risk-free rate of return

So What Does Alpha Measure

?The Jensen Index quants the capital risk premium based on beta (β), so it is assumed that the portfolio under evaluation is already diversified. good chemistry. To calculate the Jensen index, you must use a separate risk-free rate of return for each time period. For example, when evaluating fund managers’ performance year over year over a five-year period, you would subtract the rate of return per year from non-profit assets (such as bonds) treasury, or 1-year risk-free asset) for that same year, and compare the results with the difference of the annual market rate of return at the same risk-free rate.

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This calculation method contrasts with both the Treynor and Sharpe calculations, which both consider average returns over the entire period and are applied to all variables, including portfolios, markets and risk-free assets.

Alpha is a good performance measure that compares the real return with the return required for the level of risk an investor is exposed to. Technically, it’s a divergence from a portfolio’s beta that represents a measure of fund management’s quality. For example, when investors want to evaluate the success or failure of a mutual fund, they should not focus solely on actual returns, but should consider whether these returns are commensurate with the risk that the fund is taking. experience.

Application of Results

Positive alpha means that portfolio managers performed better than expected based on the risk of capital as measured by the fund’s beta. A negative alpha means that the fund’s performance is in trouble and the fund manager needs to generate a higher rate of return to achieve the required portfolio return. The results of the regression typically last between 36 and 60 months.

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In addition, the Jensen index is also a relative comparison of the performance of portfolio managers with each other, or with the market itself. When using Alpha, it is important to compare funds of the same asset class. It makes no sense to compare two funds with two different asset classes, like you would an apple and an orange.

The chart below is a typical comparison example of alpha, or so-called “residual margin”. Investors can use both alpha and beta to gauge a fund manager’s performance.

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Fund Name Asset Type Code Alpha 3 Years Beta 3 Years Total Return Yearly 3 Years Total Return Annually 5 Years American Funds Growth Fund A Strong Growth AGTHX 4.00 0.99 12.47 13.93 Fidelity Large Cap Growth Strong Growth FSLGX -4.34 1.26 4.38 8.45 T. Rowe Price Growth Stock Strong Growth PRGFX 1.39 1.17 10.28 11.22 Vanguard Growth Index Strong Growth VIGRX 0.82 1.06 9.28 9.41

The data in the figure above shows that on a risk-adjusted basis, the US Growth Fund outperforms the funds listed above. With a three-year Alpha of 4, it’s far ahead of comparable funds in this example.

It is also important to note that in addition to comparisons between properties of the same type, there should also be appropriate benchmarks. The standard commonly used to measure the market is the S&P 500 stock index, which is considered a proxy for the “market”. However, some portfolios and mutual funds include asset classes whose characteristics are not suitable for comparison with the S&P 500 index, such as bond funds, regional mutual funds, and mutual funds. sector, real estate, etc. In the above cases, the S&P 500 index is not an appropriate benchmark to use; therefore, when calculating Alpha you should also pay attention to the relative standards for that asset class.

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Conclusion

Portfolio performance is related to both return and risk. The Jensen Index, or Alpha, provides us with a reasonable standard by which to measure fund management performance. Alpha’s results can help us determine if a manager is helping the fund grow or even earn returns beyond the required return. Not only that, but this indicator also helps us to decide whether the management fee level is in line with the business results or not. Buying (or even holding) an investment fund without taking this into account would be like buying a car just for commuting regardless of its fuel efficiency.

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