What does Jensen's Alpha represent in portfolio analysis?

Jensen's Alpha is a measure of a portfolio's performance on a risk-adjusted basis. Specifically, it quantifies the excess return that a portfolio generates over the expected return, which is calculated based on the risk taken as measured by beta. In other words, Jensen's Alpha indicates how much more (or less) an investor earns from a portfolio compared to what would be anticipated based on its exposure to market risk.

The concept behind Jensen's Alpha builds on the Capital Asset Pricing Model (CAPM), which posits that the expected return on an investment is directly related to its systematic risk, as represented by beta. When Jensen's Alpha is positive, it implies that the portfolio has outperformed what was expected given its risk profile, while a negative Jensen's Alpha indicates underperformance.

Thus, the correct interpretation of Jensen's Alpha as an excess return not explained by beta captures its core essence, which is to evaluate performance beyond what is attributable to systematic market risk.