Jensen's alpha, developed by Michael Jensen in 1968, measures the abnormal return of a portfolio relative to the theoretical expected return predicted by the Capital Asset Pricing Model (CAPM). The formula is: α = Rp - [Rf + β(Rm - Rf)], where Rp is the actual portfolio return, Rf is the risk-free rate, β is the portfolio beta, and Rm is the market return. The term in brackets represents the expected return given the portfolio's level of systematic risk.

A positive alpha indicates that the portfolio manager has added value through security selection, market timing, or other active management techniques. A negative alpha suggests the manager underperformed relative to what could have been achieved with a passive index strategy at the same risk level. An alpha of zero means the manager exactly matched the risk-adjusted expectation, earning precisely the return predicted by CAPM for the level of beta exposure.

For example, if a portfolio returned 14% with a beta of 1.1, while the market returned 10% and the risk-free rate was 4%, the expected return per CAPM would be 4% + 1.1 x (10% - 4%) = 10.6%. The Jensen's alpha is 14% - 10.6% = 3.4%, indicating significant value added by the manager. Alpha is widely used in the fund management industry to evaluate portfolio manager skill, often alongside the Sharpe and Treynor ratios for a complete picture of performance.