Last May I attended a talk by Yale economist Robert Shiller in which he indicated that his company, MacroMarkets, was seeking SEC approval for a derivative product tied to home prices. Finally, this week the new “housing ETFs” are available. What are they about, and who should buy them?
For a couple of decades, Robert Shiller has wanted to invent a way to indirectly invest in residential real estate. Knowing that such a security would need to be linked to a housing market index, he and Wellesley College economist Karl Case developed the Case-Shiller indices, which have become widely-recognized tools for measuring housing market price movements.
What MacroShares Housing Trusts do
Yesterday marked the successful release of two exchange-traded trusts designed to track the S&P/Case-Shiller Composite-10 index, which reflects the sale prices of single-family housing in ten major cities. MacroShares Major Metro Housing Up (UMM) is supposed to deliver three times the return of the index, while Major Metro Housing Down (DMM) should yield triple the inverse of the index return.
There are several unusual aspects to these products. The new securities are exchange-traded trusts, not ETFs (though they’re already being referred to as ETFs). They’re intended to reflect the change in the Composite-10 index between December 31, 2008 to August 31, 2014 but they don’t track monthly housing price changes. The two trusts are set up according to a patented pairing technique. Each trust is secured by short-term Treasuries and other related securities. The two trusts basically transfer money back and forth between each other according to their price movements. Until the actual value of the index is known in late 2014, the trust share prices will be set by the market; their prices reflect buyers’ and sellers’ expectations for long-term housing prices. The two trusts are designed to close in November 2014, when investors will be paid in cash according to the August 31 index value.
The leverage feature means that it’s possible for one of the trusts’ shares to go to zero. For example, if the index went up 33.333%, the Down trust would decline by 100%. The trust terms provide that if the index goes up or down by 33.3% or more and stays that way for three months, the trusts will terminate early. This actually happened to a pair of MacroMarkets trusts linked to the price of oil in 2008; oil prices shot up so high that the “Oil Down” trust got stuck at zero.
The launch of UMM and DMM was supposed to take place in May, but it failed because of problems with price imbalances. Yesterday’s launch used a different pricing mechanism and the initial offering went forward as planned. If the offering doesn’t attract sufficient interest, MacroMarkets can terminate the trusts early.
One important aspect of the trusts is that they deliver their returns based on the change in the index over five years. This is different from a typical leveraged ETF, which can have long-term price movements that vary substantially from those of its underlying index. The trusts vaguely resemble stock options, but with some interesting twists.
Some of the risks of UMM and DMM
The trusts appear to eliminate credit risk (they’re backed by Treasury bills) and most counterparty risks (they enter into secured transactions with other parties; one of those transactions could turn sour). They sport a 1.25% expense ratio plus a variable trust fee that drops on a per-share basis as assets grow, so their returns will take a fee haircut.
Trust prices depend not only on index movement, but also on expenses. Treasuries held by the trusts generate income, and the trusts may make income distributions. But trust expenses could swamp their income and their value could decline in spite of the movement of the underlying index. If housing prices end up in exactly the same place in 2014, there could be negative returns after expenses.
DMM and UMM don’t track month-to-month movement of the housing market. Until we get close to August 2014, their price fluctuations will reflect what investors think housing prices will do in the future.
According to the product prospectuses, there are dozen or so events that could cause the trusts to terminate early. For multiple reasons, the MacroShares housing trusts might not give a return that reflects the movement of housing prices over the next five years.
The prospectuses note that the tax consequences of owning these trusts are uncertain. It’s possible, for example, that you could end up with a tax liability even though you didn’t receive a distribution or have a net gain.
Losses on your investment in the trusts are limited to 100% (unless you’re unfortunate enough to invest with borrowed money). Finally, these trusts are probably capable of failing in some way that no one has yet foreseen.
Where will housing prices be in 2014?
If the trusts survive without being terminated early, their prices will reflect the August 2014 value of the S&P/Case-Shiller Composite-10 index. As of April 2009, the Case-Shiller index is at 150.34, down by about 7.3% so far this year. The velocity of housing price declines has slowed, but the fact that we’re in the traditional house-buying season may mask the longer-term trend. So what do buyers of the trusts think housing prices will be in 2014?
When the trusts started trading on the New York Stock Exchange yesterday, UMM was trading at $19-20 and DMM at $30-31. The prices were set to $25/share as of the end of December; the current price presumably represents what the market believes housing prices will be on August 31, 2014. A move of DMM to $31 is an increase of 24%; that reflects an expected price drop of 8%. At the end of last year, the index was at 162.17; an 8% decline would put it at 149.2 in 2014 – pretty close to where it was at the end of April. So far, the pricing of UMM/DMM indicates that investors believe that housing prices won’t be much higher in August 2014 than they are now. This could imply expectations of further price drops followed by a recovery or sideways price movement for years.
Who should buy the UMM and DMM housing trusts
While I was writing this post, I received an e-mail from the fund company that markets these trusts for MacroMarkets. They contend that the trusts are useful for investors seeking to
• hedge some of the risk of owning U.S. residential real estate or mortgage-backed assets;
• speculate about a recovery in U.S. housing prices or a continued downward trend;
• diversify portfolios with an asset class that has exhibited historically low correlation to U.S. stocks.
The wording of the first suggestion is clever: hedging “some of the risk” of owning real estate or mortgage-backed assets. In fact, the MacroShares housing trusts won’t necessarily function as true hedges for owners of residential real estate for several reasons:
The trusts only reflect the Case-Shiller index’s value on August 31, 2014. Between now and then, their prices will fluctuate according to investor sentiment. The prices will certainly respond to known housing price movements, but they’ll also respond to random events like housing legislation, global economic conditions, rumors, etc. These factors may influence housing prices, but may not determine the final value of the index. A true hedge would zig when your housing price zags, and vice versa.
Even if you have a five-year window, buying DMM still might not let you hedge possible losses. Suppose you own a single-family house in one of the cities in the index and you plan to sell it in 2014 . Real estate markets are local – if the trusts work perfectly, they’ll reflect the movement of a ten-city price index, but your housing price might not follow the index. And what if you own property in a city that’s not even in the index?
Because the trusts can terminate early, they don’t offer true protection against long-term price changes. For example, suppose you plan to buy a house in three years, but you want to benefit from housing price increases now, so you buy UMM. A week later, the economy goes south, the credit markets freeze up again, and housing market expectations dive. UMM drops to zero for three months, forcing the trusts to terminate. Ten months later, inflation starts to heat up; by the time three years have passed, housing prices are higher. You lost 100% of your investment and still end up bearing the consequences of price increases.
One might be able to use these trusts as a hedge against a basket of housing-related stocks, or a homebuilder might buy DMM to hedge the risk of a market downturn. But it will be difficult to develop a quantitative scheme for setting up a true “hedge,” i.e., something that provides a gain equal to losses sustained by other assets.
I agree with the “speculating” possibility – these trusts will reflect people’s expectations for housing prices. Until we get close to August 2014, the trust prices could move all over the map based on investor feelings, with little connection to the final index value. In fact, there’s no way of knowing the motivations of current DMM/UMM investors; they could be mostly speculators. One might even use them to speculate on the passage of pending tax or housing legislation. If hedge funds get interested in these trusts, there’s no telling how they might be used.
It’s true that historically housing prices have been weakly correlated to traditional financial assets. If the trusts survive to August 2014, their return probably won’t be correlated to stock, bond, and other security price moves. But asset price correlations are always backward-looking; they can’t anticipate the future. The trusts could be used to diversify a portfolio, but there’s no guarantee that they’ll work that way.
The Bottom Line
Although the concept behind the MacroShares Major Metro Housing trusts is really cool, my sense is that most retail investors should avoid them. You definitely shouldn’t invest in them unless you’re able to comprehend the key points in their 150+ page prospectuses. In the near term I expect that DMM and UMM will primarily be useful as speculative investments tied to feelings about future housing prices.
Disclosure: Not invested in UMM or DMM at this time.
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