Six Shortcomings to Hedging Your Home Value with ETFs

by: Investment U

by Louis Basenese

No one’s talking about one of the most interesting developments in real estate this year.

And it’s not the plummeting home prices, or the spike in foreclosures.

Your home could lose half its value this year - since January 2007, countless have. And like many Americans who’ve seen their biggest asset depreciate, you’ve been completely defenseless, unable to stop it.

But that’s about to change.

I’m not suggesting the freefall in prices will stop. The latest reading of the S&P/Case-Shiller Composite 10 House Price Index makes it impossible to advance such an argument. (It’s dropped for the twenty-fifth consecutive month.) Instead, I’m telling you we’ll finally have a way to profit from retreating prices.

In other words, we can finally hedge home value in one simple step - through the use of exchange traded funds or ETFs.

Let me explain how…

A Rare IPO for Two ETFs

After five years in the planning stage, later this month, a pair of ETFs - the MacroShares Major Metro Housing Up (NYSE: UMM) and MacroShares Major Metro Housing Down (NYSE: DMM) - will IPO.

Just like Google and Morningstar, they will go public via a Dutch auction beginning April 28, organized by WR Hambrecht & Co.

That means we don’t have to worry about fighting with our brokers for an allocation if we’re interested. All we have to do is enter a competitive bid. (For more information on the bidding process go here.) Or we can just wait until the auction closes, because afterward the ETFs will trade freely on the New York Stock Exchange.

Once they do, the funds will let you hedge your home’s value, based upon changes in the S&P/Case-Shiller Composite 10 House Price Index. This benchmark measures the average price of a house in 10 major metropolitan areas:

  • Boston,
  • Chicago,
  • Denver,
  • Las Vegas,
  • Los Angeles,
  • Miami,
  • New York City,
  • San Diego,
  • San Francisco
  • Washington D.C.

(Whoever thought hedging your home value could be as simple as a 10 second E*trade transaction?)

Straightforward Exchange Traded Fund Mechanics

The mechanics of the exchange traded funds are fairly straightforward. The IPO process provides the money to capitalize both funds. In turn, the funds will go out and buy assets. They won’t be buying actual houses, though. Instead, they will purchase Treasuries to ensure liquidity. And it will be a zero sum game.

  • If the index moves up, a corresponding portion of assets from the Down ETF will be transferred to the Up ETF, raising the net asset value underlying the Up ETF.
  • And vice versa. Think of it like a financial seesaw. If one fund goes up, the other most go down by the same amount. The fund manager will shift assets between the funds to make sure it happens.
  • Of course, a Wall Street product without leverage would be sacrilegious. So it’s no surprise that the funds will employ 300% leverage, meaning a 1% move in the underlying index should result in a 3% move for the ETFs.

Bottom line: In a few weeks hedging your home value will be as simple as purchasing as ETF. At least, that’s what the brain trust behind the product, famed Yale professor Robert Shiller, would like you to believe.

Please understand the MacroShares ETFs are hardly a panacea. Or the first product aimed at hedging against home values. Back in 2006, the Chicago Mercantile Exchange started offering house-price futures and options contracts. They failed to gain traction.

Hedging Your Home Value With ETFs - 6 Shortcomings

So before you rush to hedge your home with these new ETFs, consider the six following shortcomings:

  • Liquidity. No market currently exists for these products. It’s conceivable it never will. And the last thing you want is to own an investment - other than your house - that’s impossible to unload. I’d monitor volume for several weeks before making any sizable bets.
  • Real estate is a local business. Remember, the ETFs only track prices in 10 major cities. If you don’t live in one of these markets, you won’t get a perfect hedge. Even if you do, it’s unlikely you’ll get a perfect hedge, as real estate prices can vary widely within a single zip code.
  • Single-family only. The index also only tracks prices for single-family pre-existing homes. If you own a condominium, co-op, townhouse or other type of multi-family dwelling, there is no guarantee the change in market value for these “alternate” types of housing units will be captured by the index.
  • Premium/discount. Since the Case-Shiller index is released on a two-month lag, it’s likely the ETFs will trade at a premium or discount based on market expectations. This is common for most closed-end funds, too. But just be aware of it. And realize any premium will eat into your potential appreciation and yield.
  • Income is overrated. The prospectus boasts the tax-free income potential for each ETF. However, don’t bank on a fat quarterly dividend payment. Treasury yields rest at historic lows. And before a dime of that income is funneled back to shareholders, a 1.25% expense ratio will be deducted. At best, the ETFs might yield 2% annually. As for the tax-free statement, income from Treasuries is exempt from state and local taxes. But the fund will also invest in repurchase agreements, which are not. Bottom line, the income will be a pittance and cause some headaches when tax time comes.
  • Profits are capped. The zero-sum game structure means if prices move 100% either way from their starting value, the net asset value of one of the ETFs must go to zero. Since the ETFs use 300% leverage, all it will take is a 33% move for the underlying index. So it’s a possibility. For investors looking for unlimited return potential, these ETFs don’t fit the bill.

In the end, the ETFs might have some drawbacks, but they do represent the best solution available. So if you’re afraid your home value will continue slipping in price, at least now you can do something about it.