Something very interesting is happening in the US housing market.
If you own your own home, it's not just a home but also an investment. Even if you don't intend to ever sell, your net financial worth is still a function of the property market, whether you like it or not.
Much thought has been given to disentangling these elements of 'owning' a house. Professor Susan J. Smith, at Durham University, has proposed the use of new financial instruments and contracts to allow home owners to consume accommodation, and make the sorts of alterations that would not be possible if renting, while allowing the risks and rewards of property speculation to be borne by the financial markets. This is not an easy problem to solve.
Another solution might be easily-tradeable exchange traded funds (ETFs), tracking the value of residential property, but that's not really feasible. ETFs can be created where there is a liquid underlying asset class, such as a stock index, so that new units can be created or redeemed as required, thus allowing the ETF to track the asset value very closely. With each house being unique, highly subjective in value, and taking months rather than seconds to sell, a residential property ETF would be impossible to manage.
A new solution
Now, an American investment house, co-founded by Yale economist Robert Shiller, has come up with another possible solution: a pair of exchange-traded products that allow investors to go long or short on the main American house price index, the S&P/Case-Shiller Composite 10 House Price Index.
MacroShares Major Metro Housing Up (NYSE: UMM), and MacroShares Major Metro Housing Down (NYSE: DMM), will simply invest their funds in Treasuries and cash, and on publication of the index each month, transfer asset values from one fund to the other corresponding to the movement of the index. (For reasons of efficiency, the actual transfer of assets would happen later, for example on winding up the funds -- in the meantime, there's a "binding agreement to pledge assets to one another over time".)
Investors would get three times the change in the index, so if the index is up 2%, the underlying value of long fund would rise by 6%, while the underlying value of the short fund would fall 6%, from their initial underlying values. That last point is important; the 3x percentage change is relative to their initial underlying values of $25 per share.
Different from ETFs
This is different to the daily re-setting that I've warned about with short and leveraged ETFs, and results in very different behaviour. The further the underlying values deviate from their initial $25 values, the more the subsequent changes will deviate from the 3x percentage. For example, if you bought the long fund at $15, and the index rose another 1% from its initial level, the underlying value of your long shares would be up 5% (=1% x 3 x 25/15).
So far, so good. While the 3x leverage may scare some people, I don't see it as a problem, as you just invest a smaller amount for a given exposure. Where leverage might have an impact is in the life of the fund -- a move of more than 33% in either direction from the starting value would be enough to wipe out the losing fund and close the other at a 100% gain. In practice, the funds would be wound up before getting to this point, as already happened with a pair of similarly-structured oil funds from the same company.
Another contrast to ETFs is the accuracy with which fund prices track the underlying values. The long and short funds will trade at premiums or discounts to their underlying values, depending on market expectations. It will be interesting to see how this might function as a leading indicator for house prices.
Note also that the Case-Shiller Index is issued monthly, and it lags the market by two months, so the figures issued last week (down another 1%, by the way), relate to March. Initial underlying values for the funds are the December 2008 figures, issued in February.
Will it work?
In terms of hedging the value of a current or future home, any index of house prices can only serve as an approximation to a particular property; the Case-Shiller Composite 10 Index is based on the value of single-family homes in 10 American cities. But that's the nature of an index.
As a general investment tool, much will depend on the liquidity of the shares. The initial flotation has been delayed due to difficulties balancing demand between the two funds, but it will probably go ahead this week, albeit on a smaller scale than originally envisaged.
Ignoring the income generated by the cash and Treasuries, and the total expense ratio (TER) of 1.25%, all of which are likely to be negligible in comparison to a 3x play on house prices, these products are essentially a zero sum game -- one fund's gain is the other fund's loss.
I like the simplicity of that idea, although the mechanics of making it work require some thought. As with any investment, people need to understand what they're buying, and in this case they especially need to grasp the way that the leverage multiplier varies depending on price.
Assuming the funds can achieve viable size and liquidity, I welcome anything that gives investors and home owners more choice and more information about the market. It's a pity we don't have something similar in UK.
What do you think? Would a similar product work in property-obsessed Britain? Let us know using the comment feature below.
