Jensen’s Alpha: A Key Performance Indicator in Indian Mutual Funds

Introduction

The Indian mutual fund industry has experienced significant growth over the last few years, with an increasing number of investors seeking to reap the benefits of professional management and diversification. One essential aspect of choosing a mutual fund is assessing its performance, and Jensen’s Alpha has emerged as a popular metric to evaluate risk-adjusted returns. In this blog post, we will delve into Jensen’s Alpha, discuss its advantages and disadvantages, provide a numerical example of its calculation, and review empirical evidence from research studies in the context of Indian mutual funds.

Jensen’s Alpha: An Overview

Jensen’s Alpha, developed by Michael Jensen’s in 1968, is a measure of the excess return that a mutual fund generates above its expected return, given its risk profile. It compares a mutual fund's performance to its expected performance based on the Capital Asset Pricing Model (CAPM). By analyzing the returns above and beyond the benchmark, Jensen’s Alpha helps investors determine whether the fund manager's stock-picking skills justify the fees charged.

Advantages of Jensen’s Alpha

1. Risk-adjusted performance: Jensen’s Alpha takes into account the systematic risk of a mutual fund, which is crucial for investors to consider when assessing the performance of their investments.
2. Apples-to-apples comparison: It allows investors to compare the risk-adjusted performance of various mutual funds, irrespective of their underlying assets, size, or industry.
3. Skill evaluation: Jensen’s Alpha helps in determining whether a fund manager's skill contributes to the fund's performance or if it's merely a result of market movements.

Disadvantages of Jensen’s Alpha

1. Limited scope: Jensen’s Alpha only considers systematic risk and overlooks unsystematic risk. As a result, it may not provide a comprehensive picture of a fund's risk profile.
2. Benchmark reliance: The metric is sensitive to the choice of the benchmark, which could lead to misleading conclusions if the benchmark does not accurately represent the fund's investment universe.
3. Historical performance: Jensen’s Alpha is based on historical data and may not be indicative of future performance.

 

Numerical Example

Let's consider the following data for an Indian mutual fund and its benchmark index:

• Fund's average return: 20%
• Risk-free rate: 4%
• Benchmark index return: 12%
• Fund's beta: 1.2

According to CAPM, the expected return for the fund is:

Expected Return = Risk-Free Rate + Beta x (Benchmark Return - Risk-Free Rate) Expected Return = 4% + 1.2 x (12% - 4%) = 13.6%

Jensen’s Alpha = Fund's Average Return - Expected Return Jensen’s Alpha = 20% - 13.6% = 6.4%

In this example, the Jensen’s Alpha of 6.4% indicates that the fund manager has generated a 6.4% return above what was expected given the fund's risk profile.

Empirical Evidence

Several research studies have investigated the performance of Indian mutual funds using Jensen’s Alpha. For instance, a study by Sondhi and Jain (2016) evaluated the performance of 30 equity mutual funds in India and found that the majority of the funds exhibited a positive Jensen’s Alpha. This suggests that the fund managers were successful in generating excess returns over the benchmark indices.

 

Conclusion

Jensen’s Alpha has proven to be a useful metric for evaluating the risk-adjusted performance of mutual funds. Although it has its limitations, investors can use it in conjunction with other performance measures to make informed decisions about their investments. In the context of Indian mutual funds, empirical evidence supports the notion that skilled fund managers can deliver excess returns, as evidenced by positive Jensen’s Alphas.