By Matthew Hougan
The biggest news in ETF-land over the next month could be the launch of the MacroShares home price ETFs. Or, maybe we shouldn't say ETFs.
MacroShares is going to great lengths to remind people that these are not technically ETFs; they're exchange-traded products, or ETPs. Understanding that difference is the key to understanding how these products will work—and where they should be priced.
I suspect that a lot of ink will be spilt over the coming months trying to do just that. Because they are different from traditional ETFs, and because the initial pair of MacroShares was poorly handled, MacroShares are widely misunderstood. The prospectus for these things reads like Finnegan's Wake, and the structure is unique, adding to the confusion.
But that confusion is not needed. When you get right down to it, these products are pretty simple and will work well if people understand what they are designed to do.
Here's a primer.
Home Price ETFs
The new MacroShares Major Metro Housing Up (UMM) and Major Metro Housing Down (DMM) ETPs are designed to deliver 300% and -300% of the return of the leading national home price index, the S&P/Case-Shiller 10-City Composite Home Price Index, over a specific period of time.
The last part of that sentence is critical.
Most ETFs are designed to track the performance of an index on a daily basis. The S&P 500 SPDR (SPY), for instance, is designed to track the S&P 500's return today, tomorrow and forever. The fund does that by holding all of the securities in the index. Arbitrage mechanisms exist to ensure that SPY stays close in value to the S&P 500 on a minute-by-minute basis.
UMM and DMM are different. For one, they don't hold "housing." All they hold is Treasuries. They deliver the return of the Case-Shiller index because they are contractually obligated to shift those Treasuries back and forth between the two funds based on the direction of the index: If the index goes up, Treasuries go from DMM to UMM; if it goes down, the opposite happens.
This unique structure—often called a "teeter-totter"—is what lets MacroShares track non-typical financial metrics like "house prices." Theoretically, they could be tied to anything.
The Importance of the Time Horizon
The key thing to understand about UMM and DMM is that they are designed to "expire" on Nov. 25, 2014. At that point, investors will receive a payment based on 300% of the change in the S&P Case-Shiller index over the intervening time period.
To be more specific, both UMM and DMM start with a net asset value of $25/share. That NAV is linked to the level of the Case-Shiller index as of Dec. 31, 2008. On Nov. 25, 2014, investors will be paid based on 300% of the change in the index from Dec. 31, 2008 through Aug. 31, 2014. (The end payout will be based on the August 2014 reading because the index is published with a two-month lag.)
Where should UMM and DMM trade between now and November 2014?
Simple: They should trade based on where investors expect the index to be on Aug. 31, 2014.
It's really that simple. It's like a futures contract: Everything that happens between now and expiration is mostly irrelevant.
How so? First, if the index moves 33% one way or the other in the intervening time period, the funds will be shut down and liquidated, because one of the funds will have a NAV of zero.
Second, the funds are designed to shift Treasuries back and forth on a quarterly basis based on interim readings of the index. Therefore, the amount of Treasuries each fund holds—and the amount of interest income it generates—will be influenced by the interim movements.
But that's on the edges. Really, all that matters is 2014.
What About Premiums and Discounts?
The original pair of MacroShares was designed to give exposure to crude oil. They were widely criticized because they traded at large premiums and discounts to the benchmark price of crude.
Usually, when an ETF trades at a premium or a discount, arbitrageurs will come in and make that discount go away. For instance, if SPY trades at a premium to the S&P 500 index, an arbitrageur can create new shares of SPY by buying up all the underlying stocks in the S&P 500 and delivering them to the ETF sponsor in exchange for shares of the ETF priced at NAV. They can then sell those shares into the inflated market and make a profit.
MacroShares, however, can only be created and redeemed in pairs; after all, you need an equal number of shares of each fund for the teeter-totter mechanism to work. If the Up Macro is trading at a premium and the Down Macro is trading at a discount, there's no way to make that premium and discount disappear.
That's a flaw if you expect these funds to reflect the day-to-day price changes in the benchmark index. But that's not what they should reflect: What they should reflect is an estimate of the value of the index when the product is designed to expire.
The real problem with the oil Macros was that no one knew exactly when that would be. The products were designed with a 20-year horizon, meaning they had an expiration date somewhere in the 2020s.
Twenty years is way too long. The way the products were structured, they would also be liquidated if crude traded above $100/barrel for a significant period of time. The truth is, it was almost certain that oil would trade above $100/barrel at some point in the next 20 years (as it did, in fact, in 2008, causing the funds to be liquidated). Investors in the Down oil Macro should have known that they would eventually be paid $0 for their shares.
The only question was when and how much interest income the shares would receive in the meantime. Twenty years was just too long for people to consider.
In contrast, the housing Macros have only a five-year time horizon. MacroShares actually plans to launch a new set of housing products every year, with a fresh five-year time horizon.
Will UMM and DMM trade at premiums and discounts to the current value of the S&P/Case-Shiller index in the intervening five years? Yes. But those premiums and discounts won't mean anything. Investors should basically ignore them.
They should focus on where the indexes will be in August 2014.
Update on the IPO
MacroShares is currently running an open initial public offering as it looks to raise seed capital for the products. That IPO was supposed to be completed by May 5, but was extended to May 11. It's not clear what that says about demand for the product.
Despite an overly high expense ratio (1.25%), there should be at least some demand for these products. After all, who doesn't have an opinion about where home prices are heading? These will be the first products that allow you to express that opinion from the comfort of a simple brokerage account.
