Hedging May Evolve With Five New Nasdaq OMX Indexes

Nov.24.10 | About: Nasdaq Inc. (NDAQ)

IndexUniverse reported on Tuesday that Nasdaq OMX (NASDAQ:NDAQ) recently created five indexes that could be very interesting should someone license them for exchange trade products. The idea is that the indexes track correlations between a stock and an ETF or two ETFs. The interest here is that correlations going up can be a proxy for defensive action in a portfolio that could have been part of a defensive solution (with a couple of the new indexes) during the meltdown.

The indexes are:

Nasdaq OMX Alpha AAPL vs. SPY Index (NAVSPY)
Nasdaq OMX Alpha GLD vs. SPY Index (GVSPY)
Nasdaq OMX Alpha TLT vs. SPY Index (TVSPY)
Nasdaq OMX Alpha C vs. XLF Index (CVXLF)
Nasdaq OMX Alpha EEM vs. SPY Index (EVSPY)

To be clear: The symbols are for indexes, not investable products.

It seems unlikely that the Apple (NASDAQ:AAPL) vs. SPY index or the Citigroup (NYSE:C) vs. XLF offer much in the way of defensive protection. Changes in the relationship of either stock to a related equity index (fund) would seem to be more about goings on with the individual stock than with the broad market. It is possible that at times C vs. XLF could be a proxy for a pairs trade; during a broad uptrend where C declines, the correlation could go down -- but that seems like a stretch.

The other three could play into a defensive strategy maybe as is, inverse or leveraged. According to ETF Replay, the correlation between EEM and SPY drifted lower to 0.72 into the Lehman weekend, then popped up to 0.95 in just a couple of months ... which could have worked out to a 31% pop (give or take) in an ETP tracking this relationship.

From July 2008, the correlation between TLT and SPY, again according to ETF Replay, went from negative 0.39 on July 15, 2008 to negative 0.72 on October 7, 2008 before going up to negative 0.16 on June 11, 2009 and then going back down to negative 0.78 on June 28, 2010. The moves in the correlation between GLD and SPY have been even bigger.

The moves above are big enough to matter even in the small portfolio weightings I prefer, but they would require monitoring different things than with using a "plain vanilla" inverse index fund.

I was thrilled with how inverse funds helped during the meltdown, but we also used a couple of absolute return funds, one of which did very well; the other did not do as well, but it did not blow up like some funds did. Despite my feeling constructive about the past result, I cannot rule out luck's role in making meltdown the type of perfect storm where an inverse fund really smoothed out the ride, and so must allow for the possibility that the next big decline could differ in such a way that an inverse fund somehow would do less heavy lifting.

Investing evolves, investment products evolve ... and so too should strategies evolve. Mega cap indexing worked great in the 1980s and 1990s, and it stunk in the 2000s. There are all sorts of things that used to be very important that now mean almost nothing in terms of being market-moving; when was the last time you thought about book-to-bill ratios? Things do change, hopefully for the better, and I think these indexes offer some great potential for people looking to take defensive action in the face of down a lot.

If these ever become successful ETPs, I could see the product line expanding to pit regions against each other, or country funds against broader indexes, or maybe commodities against various things.