Steady Gains

New research by Bob Whaley, the Valere Blair Potter Professor of Management, and Jacob Sagi, the Vanderbilt Financial Markets Research Center Associate Professor of Finance, has led to the creation of a recently launched group of NASDAQ indexes. The NASDAQ OMX Alpha Indexes 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—if not impossible for some—to trade directly on the relative performance of one asset compared to another.

In a new research paper 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’s share price plummeted by 32 percent, more than three times the amount lost in the broader markets. Seeing such an outsized decline in AAPL’s share price compared to the market overall may have signaled a buying opportunity to some investors. But as the financial crisis worsened, AAPL’s share price fell by another 1.4 percent. During the same time, however, the broader market fell by about 16.6 percent.

“AAPL outperformed the market as the investor expected,” 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’s 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, or betting against, a 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 so far has unveiled 23 index options tracking “highly liquid” assets, including:

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 “new return/risk management strategies to the investment arsenal.”