Alpha indexes could help investors even when the market is down
New research by Vanderbilt finance professors and has led to the creation of a recently launched group of Nasdaq indexes.
The five are designed to help investors measure performance between individual stocks and exchange-traded funds. In practice, this means that the returns of popular holdings such as Apple and Citigroup could be isolated from sharp swings in the market. Traditionally it has been difficult鈥斅璱f not impossible for some鈥攖o trade directly on the relative performance of one asset compared to another.
In a describing how relative performance indexes work, Sagi and Whaley use the example of Apple (AAPL) compared to the S&P 500.
In September 2008 AAPL鈥檚 share price plummeted by 32 percent, more than three times the amount lost in the broader markets. Seeing such an outsized decline in AAPL鈥檚 share price compared to the market overall may have signaled a buying opportunity to some investors.
But as the financial crisis worsened, AAPL鈥檚 share price fell by another 1.4 percent. During the
same time, however, the broader market fell by about 16.6 percent.
鈥淎APL outperformed the market as the investor expected,鈥� Sagi and Whaley write. But anyone who had purchased shares of AAPL, while beating the market, would still have suffered a loss.
If an investment tool based on a relative performance index had been available to capture AAPL鈥檚 performance against the market, however, it would have yielded a substantial gain.
To try and replicate that same trade using the tools available at the time, an investor would have had to buy a long position in AAPL, while shorting鈥攐r betting against颅鈥攁 product like an S&P 500 index fund.
The central risk in that scenario is that an investor would be exposed to an unlimited loss in the short position. By contrast, a relative performance index would place at risk only the original amount of the investment. Further, the money and time spent rebalancing those trades to account for volatility in both the long and short position would be too much for most investors to bear.
While the derivative products on the indexes developed by Sagi and Whaley can be used to invest in the relative performance of any pair of securities or exchange-traded funds, Nasdaq OMX has so far launched five offerings tracking 鈥渉ighly liquid鈥� assets with plans to add more in the near future:
- AAPL vs. SPY Index (symbol: AVSPY)
- Gold (GLD) vs. SPY Index (symbol: GVSPY)
- Twenty-plus Year Treasury Bonds (TLT) vs. SPY Index (symbol: TVSPY)
- Citigroup (C) vs. Financial Sector (XLF) Index (symbol: CVXLF)
- Emerging Markets (EEM) Index vs. SPY Index (symbol: EVSPY)
For now, Sagi and Whaley see the relative performance indexes as providing an easy and low-cost way to execute what traditionally has been a cumbersome trade.
But as these indexes become more widely used, the authors say, they could introduce entirely 鈥渘ew return/risk management strategies to the investment arsenal.鈥�
If approved by the Securities and Exchange Commission, the Alpha Indexes will begin trading in early 2011 on the NASDAQ OMX PHLX exchange in Philadelphia.
Sagi is Associate Professor of Finance at the ; and Whaley is Valere Blair Potter Professor of Management at Owen. Whaley, creator of the CBOE鈥檚 Market Volatility Index (VIX), also serves as co-director of the Financial Markets Research Center.
You can read Whaley and Sagi鈥檚 research, titled 鈥淭rading Relative Performance鈥� at .
Vanderbilt Owen Graduate School of Management is ranked as a top institution by BusinessWeek, The Wall Street Journal, U.S. 狐狸视频 & World Report, Financial Times and Forbes.
[Media Note: Vanderbilt has a 24/7 TV and radio studio with a dedicated fiber optic line and ISDN line. Use of the TV studio with Vanderbilt experts is free, except for reserving fiber time.]