An active fund manager delivers an annualized return of 20.5% with a Beta of 1.25. The market index benchmark return is 14.0% and the risk-free rate is 6.0%. What is the Jensen's Alpha generated by the fund manager?

[ A ]+4.50% p.a. (Superior active stock selection alpha exceeding CAPM benchmark: 20.5% - 16.0%)[ CORRECT ]

[ B ]-4.50% p.a.

[ C ]+6.50% p.a. (Simple excess return over market index: 20.5% - 14.0%)

[ D ]+16.00% p.a. (CAPM Expected Return)

Takeaway

Option A is correct: +4.50% p.a. (Superior active stock selection alpha exceeding CAPM benchmark: 20.5% - 16.0%)

Derivation

First find what CAPM predicts the fund should have earned given its risk: Expected Return = R_f + Beta × (R_m − R_f) = 6.0% + 1.25 × (14.0% − 6.0%) = 6.0% + 1.25 × 8.0% = 6.0% + 10.0% = 16.0%. The fund actually delivered 20.5%. Jensen's Alpha is simply the gap between what happened and what CAPM said should have happened: 20.5% − 16.0% = +4.50% p.a. A positive alpha means the manager beat the return that Beta-driven market exposure alone would justify — genuine stock selection skill, not just riding a high-Beta portfolio in a rising market. Candidates often compute the 16.0% CAPM benchmark correctly but then subtract in the wrong direction or forget to run the CAPM step at all.

Why the others fail

B — -4.50% p.a.

Reverses the sign of a genuine outperformance; the fund beat its CAPM-implied return of 16.0%, so alpha is positive, not negative.

C — +6.50% p.a. (Simple excess return over market index: 20.5% - 14.0%)

Subtracts the raw market index return of 14.0% instead of the Beta-adjusted CAPM expected return of 16.0%, so it ignores the fund's higher-than-market risk.

D — +16.00% p.a. (CAPM Expected Return)

Quotes the CAPM expected return of 16.0% itself rather than the gap between actual return and that benchmark, which is what alpha measures.