19th letter to friends of Brunei [Portfolio Management (Part 5)]

The 3rd commonly used risk-adjusted portfolio return measure is the Jenson measure. This measure, denoted by α (alpha), compares the actual return of a portfolio against its expected return. (As we have learnt earlier, the expected return of a portfolio can be found using the CAPM model)

α = Actual Portfolio Return – Expected Portfolio Return

= Actual Portfolio Return - [Rf + β (Rm – Rf)]

Let's do an example: A-fund has a beta of 1.5 in STI. In 2008, A-fund recorded a 18% return, and STI recorded a 10% return. Calculate its Jenson measure. (assuming risk free return = 4%)

α = Actual Portfolio Return (18%) – Expected Portfolio Return [4% + 1.5 ( 10% - 4%)]
= 18% - [4% + 9%]
= +5%

From this α (of +5%), A-fund manager is said to have outperformed the market.

(A positive α means a portfolio manager outperforms the market, a negative α means the portfolio manager underperforms the market)

The hedge fund managers always use α to denote how good (or bad) they are (compared to each other).