MBA (Finance) – IV Semester, Investment and Portfolio Management, Unit 5.3
Define Jensen’s Performance Index
The absolute risk adjusted return measure was developed by Michael Jensen and commonly known as Jensen’s measure. It is mentioned as a measure of absolute performance because a definite standard is set and against that the performance is measured. The standard is based on the manager’s predictive ability. Successful prediction of security price would enable the manger to earn higher returns than the ordinary investor expects to earn in a given level of risk.
Jensen’s Performance Index
The absolute risk adjusted return measure was developed by Michael Jensen and commonly known as Jensen’s measure. It is mentioned as a measure of absolute performance because a definite standard is set and against that the performance is measured. The standard is based on the manager’s predictive ability. Successful prediction of security price would enable the manger to earn higher returns than the ordinary investor expects to earn in a given level of risk.
The basic model of Jensen is given below
The return of the portfolio varies in the same proportion of 13 to the difference between the market return and riskless rate of interest. Beta is assumed to reflect the systematic risk. The fund’s portfolio beta would be equal to one if it takes a portfolio of all market securities. The 13 would be greater than one if the fund’s portfolio consists of securities that are riskier than a portfolio of all market securities. The figure shows the relationship between beta and fund’s return.
Any professional manager would be expected to earn average
portfolio return of R = R1 + 1 (Rm_ Rf). If his predictive ability is superior,
he should earn more than other funds at each level of risk. If the fund manager
has consistently performed better than average Rp, there would be some constant
factor that would make the actual return higher than average R. The constant
may be that represents the forecasting ability of the manager. Then the
equation becomes
By estimating this equation with regression technique, Jensen claimed a the constant, reflected the professional management’s ability to forecast the price movements. A comparative analysis of three hypothetical funds A, B and C are given in the figure.
Fund A’s αp is equal to the risk free rate of return. If no risk is undertaken, the portfolio is expected to earn at least Rf. It is hypothesized that it takes no particular professional managerial ability to increase the return Rp by increasing (Rm – Rf). In the fund C, the manager’s predictive ability has made him earn more than Rf. The fund manager ‘would be consistently performing better than the fund A. At the same time if the profession management has not improved, it ‘would result in a negative a. This is shown by the line B. Here the is even below the riskless rate of interest. Jensen in his study of 115 funds, he found out that only 39 funds possessed positive a and employing professional management has improved the expected return. On an average, fund’s performance is worse than expected, without professional management and if any investor is to purchase fund’s shares, he must be very selective in his evaluation of management. Thus, Jensen’s evaluation of portfolio performance involves two steps.
Using the equation the expected return should be calculated.
With the help of 3, Rm
and R,, he has to compare the actual return with the expected return. If the
actual return is greater than the expected return, then the portfolio is
considered to be functioning in a better manner. The following table gives the
portfolio return and the market return. Rank the performance.
The return can be calculated with the given information using the
formula:
The difference between the actual and expected return is compared.
Among the risk adjusted performance and of the three portfolios, A
is the best, B - the second best and the last is the C portfolio.
