Jensen's Alpha

Jensen's Alpha shows how much more (or less) the actual return was, compared with the expected return predicted by the CAPM (Capital Asset Pricing Model).

The formula is this. Alpha = actual return - [risk-free rate + beta × (market return - risk-free rate)]. What's inside the brackets is the expected return that 'the CAPM says you should earn for this level of risk.' If the actual return is higher than that, alpha is positive (+).

Simple excess return (my return - benchmark) does not account for risk. If you took on twice the risk to earn twice as much, the excess return may look large, but that isn't skill.

Jensen's alpha first draws a baseline that says 'for the risk you took on (beta), you should have earned at least this much,' and recognizes only the portion above that line as alpha. That's why alpha is a strict measure of 'whether the manager truly added value relative to the risk taken.'

Because Jensen's alpha relies on the CAPM and beta, if this model's assumptions break down, alpha is distorted too. The value changes depending on which market index you use and over what period you estimate beta.

Also, a positive (+) alpha over a short period may be luck. And alpha is usually a figure before subtracting costs, so once you reflect fees and transaction costs, it often disappears. In reality, it is rare for a fund to consistently generate positive alpha over a long period even after deducting costs.