Alpha Returns

CFA Level I Portfolio Management
#1

I’ve been looking over the Treynor Measure and Jensen’s Alpha and I am slightly confused. Maybe someone can enlighten me?.. (please correct me below where applicable)

Taking into account the efficient frontier and the two fund seperation theorem; every investor will use the same risky portfolio (the market portfolio) and combine it with the risk free asset.

The expected returns will differ primarily on the choice of weightings of the market portfolio and the risk free asset.

“Jensen’s alpha for Portfolio P is calculated as Rp - [Rf + B(Rm - Rf)] and is the percentage portfolio return above that of a portfolio (or security) with the same beta as the portfolio that lies on the SML.”

In a CAPM world…“the expected returns on all portfolios , well diversified or not, are determined by their systematic risk.”

So I guess my question is, according to this theory, how can a portfolio have the same beta to a portfolio that lies on the SML but earn a higher expected return? or equivalently have a steeper slope (measured by the Treynor measure) than the SML?

#2

It’s not that the portfolio has a higher expected return than a portfolio on the SML with the same beta: it’s that the portfolio has a higher _ actual _ return than predicted by the SML. Jensen’s alpha is calculated ex post, with the actual return; sometimes expected returns and actual returns differ.

#3

Thanks S2000magician! :slight_smile: so the securities that lie above the SML are not appropriately priced and infact are undervalued resulting in alpha returns?

The term “not properly priced”, do you know what that actually means? Is it that the beta has been calculated incorrectly, i.e. inflated?

#4

It’s because the paramaters used to calculate the efficient frontier (or the CAPM) are estimated (i.e. ex-ante). If there was perfect foresight actual (i.e. ex-post) returns, betas, covariances, etc… would be the same as what was projected. This bears little resemblance to the real world, so some securities end up with positive alpha, and some with negative.

Properly priced means that projected = actual.

#5

thanks busprof !