Alpha Indexes

Brendan Conway (WSJ) recently wrote an article that grabbed my attention.[Addendum: Article no longer available online]

He describes 'Alpha Indexes,' which are scheduled to debut for trading early next year, if the SEC approves.

The exchanges (and others who create special indexes and ETFs) are constantly seeking new products to attract the attention of investors and traders, even when those products are known to hurt naive individual investors.  One major example is the listing for trading of leveraged exchange traded funds.  The disclosures are there.  The warning is available to investors, but people do not read the fine print.  For example, I know that I've never read the fine print in a credit card agreement.  Investors just assume a product is what it apppears to be.  Often that is a very bad assumption.  But, I digress.

 

What is an Alpha Index?

An alpha index for a specific investment (AAPL stock, for example) increases in value when the stock outperforms a specified benchmark index.  It loses value when the stock underperforms its benchmark.  Pretty simple, right?

The details have not been announced, but I fear that this simple idea will be too complex for many individual investors.  Time will tell.

The benchmark index varies, depending on the underlying asset.  For example, Citigroup's alpha index will use a financial index as its benchmark.  AAPL may use the S&P 500, or a different index that is more heavily weighted in technology.


The good news

An investor can place a wager that his/her stock pick will do better than its benchmark.  When buying stock, there is always the risk of a huge stock market decline.  Owners of AAPL index shares do not have to be concerned with whether the market rises or falls.  All that matters is whether the stock outperforms its benchmark.

More good news:  The market tumbles by 25% but your stock declines by merely 20%.  Congrats.  You earn a profit.

Nervously bullish investors may prefer to own an alpha index, rather than stock.  They would not have to be concerned with a market decline.  Their investment is based on realtive performance.

 
The other side

Of course, there's the other side of the issue.  You like JNJ, a very conservative stock and decide to buy some JNJ alpha index shares.  Imagine owning that steady performer  in a strong bull market.  Your underlying stock has an outstanding year and  rises by 15%.  However, the benchmark increases by 30%.  That results in a sizable loss for the alpha investor.  Because the details have not been published, the size of that loss is currently unknown.

Two things are immediately obvious:

  • When you are bullish, you cannot buy alpha indexes for non-volatile stocks.  Volatility is your friend when you buy an alpha index in a rising market.
  • When defensive, and anticipating a steady or declining market, that's the time to own an alpha index on a non-volatile stock.  A small increase or decrease in the price of the underlying should be enough to outperform the benchmark in a falling market.

Much to consider

Before using these vehicles, an investor must be very careful.  The volatility of alpha indexes for volatile stocks will be very high.  Imagine trading options [I'd be shocked if options were not listed quickly] on this very volatile product.  

I find the concept behind the alpha indexes to be intriguing.  I see the merits.  But I fear it will become just another tool for gambling.

Whenever we choose stocks to own, we are surely making the bet that our stocks will outperform.  We believe we are picking stocks that will do better than average. Thus, buying alphas seems to be a reasonable play.  For investors who don't believe they can beat the market, passive investing (index funds) are, and will remain available.

Consider what happens when your chosen stock rises significantly.  As a shareholder, you earn a very nice profit.  However, as an alpha index owner, your profit may be very small because the benchmark fared nearly as well as your stock.  Instead of a nice profit, you have a small profit.  And when the benchmark slightly outperforms your stock, you lose money.  This is the risk that most investors will fail to see.

To me, this has nothing to do with investing and is another tool which traders can use for gambling purposes.  Although this appears to be an excellent product, and experts have been hired to work out the details, I'm concerned about the gambling aspects of this new vehicle.

Predictions

The SEC will fail to do its job to limit useless new products:

Instead of encouraging traders to short specific alpha indexes, we are sure to see inverse alphas.  Perhaps they will be named omega (last letter of Greek alphabet) indexes.

Leveraged alphas are another useless possibility.  The alphas may not be sufficiently volatile for some, and perhaps we will be forced to tolerate 2x and 3x leveraged alphas.

826

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5 Responses to Alpha Indexes

  1. Tyler's Trading 11/04/2010 at 10:28 AM #

    Great Write-up Mark. I believe it’s the first and most informative intro I’ve come across thus far on these Alpha indices. I think you have a winning idea with the name of a potential inverse – the Omega Index. I can imagine the types of headlines that could be created off of Alpha and Omega.
    http://www.tylerstrading.com

  2. Mark Wolfinger 11/04/2010 at 10:34 AM #

    Thanks Tyler,
    Plus this can be an interesting topic, worthy of some educational/critical blog posts.
    I just hope this is not another harsh lesson for less sophisticated traders.

  3. Bill 11/04/2010 at 1:05 PM #

    Mark,
    I know you’re teaching options here, but I thought I’d give it a shot and ask you a question about how bond ETFs work.
    I sort of know how buying U.S. T-Bills/Bonds work because I’ve done it before. If I purchase a $100 T-Bill (just for example), I might pay $99 for it and I will get $100 at maturity. I can also sell the T-Bill before maturity if I wanted to, maybe for partial interest gain. But if I keep it until maturity, I’m GUARANTEED to make money, assuming no U.S. default.
    If I buy a bond ETF, such as SHY (1-3 yrs) or TLT (20+ yrs), is this like buying a basket of bonds where I could hold on to the ETF and eventually be GUARANTEED to make money on it (minus administration cost). I know people like to short-term trade the ETFs for price fluctuations of bonds, but is there any sort of long-term guarantee to profit if I just hold on to the ETF, similar to simply holding on to T-Bills until its maturity? I tried reading the literature but I still don’t understand the mechanics of bond ETFs very well. Thanks.

  4. Mark Wolfinger 11/04/2010 at 1:30 PM #

    Bill,
    I appreciate your taking the shot, but I know essentially nothing about bond investing in any form.
    But I know this (from personal experience many years ago). A bond fund or a bond ETF is NOT guaranteed.
    It’s amazing that the literature (prospectus) is not written clearly so that everyone can understand. But that’s the way it is and we can do nothing about it.
    These ETFs do not just sit and hold the bonds forever. Their goal is NOT to collect interest and thereby profit. The goal is to mimic the index. That is NOT the same as investing in bonds to maturity.:
    “The iShares Barclays 1-3 Year Treasury Bond Fund (SHY) seeks to approximate the total rate of return that correspond generally to the price and yield performance, before fees and expenses, of the short-term sector of the United States Treasury market as defined by the Barclays Capital U.S. 1-3 Year Treasury Bond Index.”

  5. Bill 11/04/2010 at 2:52 PM #

    Mark, I appreciate your reply. I need to do more research on bond indexes before I invest in them. Thanks. Bill