DEFINITION of Tainted Alpha
Tainted alpha refers to the portion of alpha return that cannot be attributed solely to the money manager due to consequential beta exposure. Tainted alpha is seen when money managers invest in individual equities, instead of using market neutral strategies such as arbitrage and hedging.
BREAKING DOWN Tainted Alpha
Tainted alpha is attributable to the beta exposure of the underlying stocks within a client portfolio. Beta exposure is return that is attributable due to the movement of the overall market. Most stocks have a portion of their total return during a given period that is attributed to general market movement. Since it is impossible to completely strip out the portion of return that is due to overall market movement when investing in a long only portfolio, it is a common occurrence that part of a portfolio manager's excess return will be attributable to this beta. For most investors this idea is acceptable due to the benefits of passively capturing gains that are associated with long term beta exposure, along with a money manager's stock picking ability. Due to many individual investors being unable to invest in funds that use pure alpha strategies (i.e. hedge funds), tainted alpha is common among the majority of managed portfolios.
Example of Tainted Alpha
Bert runs a concentrated portfolio of growth stocks. The index for the portfolio is the S&P 500. Many of the stocks in Bert's portfolio happen to be high beta stocks. He has picked them based upon a model and analysis method he developed himself. The fact that most of the stocks in his portfolio is purely a coincidence. The S&P 500 goes up 4% during the period. Bert's portfolio gains 6% over the same period. It would appear that Bert's alpha is 2% for the period since that is the amount by which he beat the index. However, the beta of his portfolio is greater than 1, the beta of the overall market. This means the stocks in his portfolio go up more than the market when the market goes up. Even though Bert picked the stocks based upon his proprietary model and methods, it can be said that part of the portfolio's alpha is actually due to the high beta of the underlying securities.