When a portfolio performs well, the obvious question is whether that performance came from skill or simply from taking more risk. Jensen’s Alpha is designed to answer exactly that. It isolates the portion of return that cannot be explained by market exposure alone.

Because of this focus on skill versus risk, Jensen’s Alpha is a core concept in portfolio performance evaluation and is frequently tested in CFA and FRM exams.

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What Jensen’s Alpha Really Measures

Jensen’s Alpha measures the excess return earned above what is expected for a given level of market risk.

The expected return is determined by the portfolio’s beta and the market return. If the actual return exceeds this benchmark-adjusted expectation, the alpha is positive. If it falls short, the alpha is negative.

In simple terms, Jensen’s Alpha asks whether the manager added value beyond market movements.

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Why Beta Is Central to Jensen’s Alpha

Beta plays a key role because Jensen’s Alpha is rooted in asset pricing theory.

The logic is that investors should be compensated for bearing systematic risk, but not for taking diversifiable risk. Beta captures exposure to market risk, allowing the model to separate risk-based returns from manager skill.

This distinction is central to how exams frame alpha-related questions.

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Interpreting Positive and Negative Alpha

A positive Jensen’s Alpha suggests that the portfolio outperformed its risk-adjusted benchmark. This is often interpreted as evidence of superior security selection or timing.

A negative alpha indicates underperformance after accounting for market risk. Importantly, this does not necessarily imply poor returns in absolute terms, only that returns were lower than what risk exposure would predict.

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Jensen’s Alpha vs Other Performance Measures

Jensen’s Alpha differs from ratios like Sharpe or Treynor.

While Sharpe and Treynor measure return per unit of risk, Jensen’s Alpha measures absolute abnormal performance. It focuses on value added, not efficiency.

Understanding this difference helps in questions that ask which measure best evaluates manager skill.

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Assumptions and Limitations

Jensen’s Alpha relies on assumptions that matter.

It assumes the asset pricing model used is valid and that beta remains stable. If the benchmark or beta is poorly chosen, the alpha can be misleading.

Exams often test whether candidates recognise these limitations rather than applying the measure mechanically.

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Common Student Errors

Many students confuse alpha with excess return. They are not the same.

Others assume a positive alpha guarantees future outperformance. It does not.

Some forget that alpha depends on the chosen benchmark.

These misunderstandings are common exam traps.

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Final Perspective

Jensen’s Alpha is best viewed as a measure of value added beyond market risk. It helps distinguish between returns driven by exposure and returns driven by skill. For exam preparation, focus on understanding what alpha represents, how it differs from risk-adjusted ratios, and when its interpretation may be misleading. Once this framework is clear, Jensen’s Alpha becomes a powerful and intuitive concept.