Alpha, as we know it, is actually called Jensen’s alpha, RP – [RF + βP (RM – RF)], which is one of the many measures of active management skill. Although routinely applied to evaluate performance of traditional long-only investments like mutual funds, it is not necessarily appropriate to compare among hedge funds which are known to apply leverage and take long and short positions.
Question) To the extent that hedge funds apply various degrees of leverage, do you think the Jensen’s alpha take this factor into account? Do you think Jensen’s alpha will over- or under-state skill in the presence of leverage? Please explain. If your answer is yes, please suggest some simple modification to Jensen alpha to take leverage into account.