Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Tainted Alpha

What it is:

Tainted alpha is the portion of a security's or portfolio's return that is not attributable solely to the skill of the investor or portfolio manager.

How it works (Example):

Alpha is the portion of a security's or portfolio's return that is not explained by the market or the security's relationship to the market but rather by the skill of the investor or portfolio manager. When beta -- a measure of an asset's risk in relation to the market -- also affects alpha, we call the alpha tainted alpha.

For example, mathematically, alpha is the rate of return that exceeds what was expected or predicted by models such as the capital asset pricing model (CAPM). To understand how it works, consider the CAPM formula:

r   =   Rf  + beta x (Rm - Rf )   +   alpha

where:
r = the security's or portfolio's return
R = the risk-free rate of return
beta = the security's or portfolio's price volatility relative to the overall market
Rm  = the market return

The bulk of the CAPM formula (everything but the alpha factor) calculates what the rate of return on a certain security or portfolio ought to be under certain market conditions. So if this portion of the model predicts that your portfolio of 10 stocks should return 12%, but it actually returns 15%, we would call the 3% difference (the "excess return") alpha. If some of that 3% is due to the specific risk exposure of one or more of the stocks, then the alpha is tainted -- it's not just due to the manager's skill.

Why it Matters:

Alpha is a measurable way to determine whether a manager has added value to a portfolio, because alpha is the return attributable to the skill of the portfolio manager rather than the general market conditions. Tainted alpha, however, dampens the manager's image.

The very existence of tainted alpha is controversial because those who believe in the efficient market hypothesis (which says, among other things, that it is impossible to beat the market) believe alpha is attributable to luck rather than skill; they support this idea with the fact that many active portfolio managers don't make much more for their clients than those managers who simply follow passive, indexing strategies. Thus, investors who believe managers add value accordingly expect above-market or above-benchmark returns -- that is, they expect at least some untainted alpha.