Trading Relative Performance with Alpha Indexes

Relative performance is central to investment management, and yet relative performance securities do not trade directly. Complex trading strategies must be devised to capture relative gains. The authors introduce a suite of relative performance indexes and index derivatives that offer new and attractive payoff structures. They demonstrate a variety of ways in which these products can provide a more efficient and cost-effective means of realizing investment objectives than can traditional futures and option markets.Relative performance is at the heart of investment management. Many stock portfolio managers focus on identifying under- and overpriced stocks in hopes of “beating the market.” Commonly referred to as “stock pickers,” these managers take long and short positions in stocks on the basis of their company-specific analyses and price predictions. Other stock portfolio managers operate globally and focus on identifying under- and overpriced stock markets; these managers are also stock pickers, but of country-specific rather than company-specific performance. Large institutional investors, such as pension fund managers and university endowments, spread fund wealth across many asset categories, including stocks, bonds, and real estate. They constantly monitor the relative performance of each asset category in deciding how to allocate fund wealth.As these examples illustrate, investment managers pit the performances of individual securities and security portfolios, both domestic and international, against one another. Although relative performance remains the central focus of investment management, relative performance securities do not exist. To create the payoff contingencies that relative performance securities would offer, investors sometimes piece together different positions in exchange-traded securities to structure a relative performance position. Typically, these strategies are complex and, in many instances, very risky. For example, if a stock picker believes that a particular stock will outperform the market, she can buy the stock and sell the market by using such index products as exchange-traded funds and index futures. But such a position has unlimited liability. To avoid the downside, the investor can dynamically manage the position by shifting from stocks to risk-free bonds as the market rises (and vice versa). But constantly migrating funds from one security to another in response to a change in expected performance is cumbersome and costly. Alternatively, the investor can go long relative performance and limit the downside by buying a call on the stock and a put on the market. Although this strategy limits the downside, it is unduly expensive because it entails paying unnecessarily for the market volatility embedded in both the call and the put option premiums. Exchange-traded products for relative performance promise to be a simple and cost-effective means for providing investors with investment opportunities that are otherwise inaccessible.In October 2010, NASDAQ OMX laid the groundwork for introducing relative performance index product markets by computing and disseminating in real time several indexes, each measuring the relative total return of a single stock against the Standard & Poor’s Depositary Receipt exchange-traded fund. Among the names currently available are AAPL, GE, GOOG, IBM, and WMT. Although these indexes themselves do not trade, the U.S. SEC approved NASDAQ OMX PHLX’s application to list exchange-traded option contracts on 7 February 2011, and the first relative performance index option market was launched on 18 April 2011. In our study, we analyzed a suite of relative performance indexes and associated derivatives (futures and options). To begin, we proposed a specific measure for calculating a “relative performance index” of a target security versus a benchmark security. We then described how futures and option contracts written on relative performance indexes might be structured and how such contracts could be valued. Finally, we provided a set of scenarios in which relative performance index derivatives are shown to be a more cost-effective means of trading relative performance than are traditional futures and option markets.