Jensen Alpha and Market Climate

This paper studies the impact of market climate on the classic Jensen alpha (JA) of funds. We show analytically that the one-factor JA of a fund consists of i) the fund's alpha based on the assumed multi-factor model and ii) further components that are subject to market phases of factor realization. To account for this impact of market phases in the performance evaluation of funds, we apply a time period-adjusted JA. In our empirical study, we analyze JAs and respective fund rankings for a survivorship bias-free data set of 3.102 US equity mutual funds. Our results show that factor realizations during the specific lifetime of a fund clearly affect its rank position. This impact is particularly strong for funds with shorter lifetimes. Using the time period-adjusted JA clearly reduces this impact. Our main results are robust when applying alternative multi-factor models as a return generating process