Update on MacroShares' Housing Funds

by: Ed Hynes, CFA

Note: A few sections of this article are similar to my piece published in April.

The MarcoShares Major Metro Housing UP and DOWN shares finally made their debut yesterday morning. This birthing has been long and difficult so let’s hope their future is brighter and easier.

Yesterday’s volume was negligible and so any comment about the price action needs to be taken with a grain of salt. With that warning in mind, the Major Metro Housing UP (UMM) shares closed at $19.60 and the Major Metro Housing DOWN (DMM) shares at $30.90.

These shares are based on the S&P/Case-Shiller Home Price 10-City Composite index, but as we will see below are not meant to track the index. Yesterday’s release of the index, with data through April coincided with the start of trading and, as in recent months the data is mixed. Both bulls and bears can find points to buttress their positions. Here is a chart of the Index.

It is hard to see any good news here and bears will certainly point to the continued steep decline. Bulls, on the other hand, take more comfort in the next chart, which shows the pace of year over year declines has stabilized. I would agree that a stabilization in declines is good, and clearly a necessary first step, but prices continuing to fall at 18% a year is scary.

The Bulls will also note the improving trend in monthly comparisons in 7 out of the 10 cities in the index. This could be positive but investors should be cautious because changes in home prices are notoriously seasonal and as the graph shows, tend to increase in the spring (more on this later). Another negative factor for the SP/CS Comp-10 index is shown on the next charts. Although California cities (LA in particular) appear to be stabilizing; New York’s price pattern is not so hot and the region has so far failed to see a spring bounce.

So where do investors think this index will be in November 2014? That is what the new MarcoShares Major Metro Housing UP and DOWN shares are designed to answer and some explanation is warranted before going further.

In very simple terms, there are two shares: the Major Metro Housing UP (UMM) and Major Metro Housing DOWN (DMM). When the product was designed each share was worth $25 and the pair $50. The product to structured to be 3 times leveraged to the percentage change in the index so based on yesterday’s published Index of 150.34 (Chart 1), the UP shares now have an Underlying Value of $19.53 and the DOWN shares $30.47.

If the Index goes up from its initial value of 162.17 between now and the product’s expiration in November 2014, the assets from the DOWN shares will pay the UP shares 3 times the percentage increase in the Index based on the initial $25. Alternatively if the Index falls, the UP shares will pay the DOWN shares a similar amount.

Using the correct terminology to discuss these products is critical to understanding them. Each traded share represents a portion of an underlying trust which in general terms will hold $25 of U.S. Treasury securities per share and a settlement agreement with the other Trust that will be executed at maturity. So the Net Asset Value or NAV of each Trust will always be about $25.

An important new term is the “Underlying Value” of the Trust which takes into account both the $25 and the “current” value of the settlement agreement if it expired yesterday. This Underlying Value should correspond to the current level of the published index.

Finally we have the share price, which is where the shares trade on the open market. If the product works, the market price will differ from the share’s Underlying Value and reflect investor expectations of where the index will be in November 2014.

The underlying mechanism of these shares, when paired together as one UP and one DOWN share, is similar to an Exchange-Traded Fund (ETF). And like an ETF, paired shares can be created and redeemed at $50 which is also the paired shares NAV and their Underlying Value. In essence, investors get the tax and trading efficiencies of ETFs in a product where the share price is not wedded to the underlying NAV.

Let’s run through an example. The initial Index level is 162.17 and both shares start at an NAV and Underlying Value of $25. If the Index is back to 162.17 in November 2014, the ending NAV and Underlying Value will be $25. If the Index increases 10 percent from 162.17 to 178.39, the DOWN shares will pay the UP shares 3 times the 10 percent change or 30 percent of $25; which equals $7.50. With the additional $7.50 the UP shares will be worth $32.50 ($25 + $7.50) at expiration while the DOWN shares will be worth only $17.50 ($25 - $7.50).

Not surprisingly, the initial trading of the shares yesterday centered on their Underlying Values. As a rough short-hand calculation, every 2.1624 Index points equals a $1 change in Underlying Value. So with the index falling 11.83 points from 162.17 to 150.34, the Underlying Value for the UP shares has fallen $5.47 to $19.53.

I hope it is clear investors need to be careful and understand that the price of these shares will often represent expectations, not the current Underlying Values. If you buy DOWN shares at $35 and the index does not move you will lose money. To make money with that purchase, the index must be below 140.55 at expiration. However, in the meantime, if “expectations” improve or deteriorate the shares may offer other profit (or loss) opportunities.

The underlying SP/CS Comp-10 Index measures single-family housing prices in the country’s 10 largest cities. The index weights cities by the value of their housing stock and almost 50% of the Index is accounted for by New York (27.2%) and Los Angeles (21.2%). At the other end of the spectrum is Las Vegas which receives a lot of attention, but only has a weight of 1.5%.

The S&P/Case-Shiller Indexes use a technique called “Repeat Sales Methodology” for measuring the change in home prices. When a home is sold “at arms length” they look for the previous sales transaction of that exact same house and calculate the change in price with a few minor adjustments if necessary. Investors should note that foreclosure sales “at arms length” are included in the index; while newly built homes are not included as there is no “previous” sale. More information on the index is available on the S&P website.

The Index, published at 9:00 a.m. on the last Tuesday of each month, is a rolling three-month average and released with a two-month time lag. So for example, the data just released on June 30 was for the three-month period of February/March/April.

As with any new structured product there are a number of issues investors should be aware of and prospectuses are available at MacroMarkets’ website. The site also has information on the fund’s relatively rich 1.25% expense ratio and some tools for investors.

Some of the critical concerns for investors will be the shares’ liquidity and bid/offer spreads. When futures contracts on this Index started trading a few years ago, things started out pretty well, but then faded quickly.

Investors who plan on actively trading the shares should also understand the seasonality of the Index. Home prices tend to get a boost in the 1st half of the year and slow down in the 2nd half. Obviously, none of this matters at expiration, but it can be important when analyzing trends from month to month. For instance, investors should know that the release of April data (like yesterday’s release) often shows a positive monthly trend and has done so in 17 of the last 21 years. On the other hand, January’s release of November data almost always documents a decline in the rate of change (20 out of 21 years).

As explained above, any gain for the UP or DOWN shares is funded by the corresponding fund on a leveraged basis. Since the losing fund can eventually run out of money, the whole structure will shut down and terminate if the Index moves more than 33.3 percent (outside the range of 108.12 to 216.22) for three consecutive months and either the UP or DOWN shares will get all $50 (see Chart 1 for boundaries). If the Index gets close to either limit, but especially the lower one in the foreseeable future, expect traders to shift their focus from the likely Index level in 2014 to the probability of an early termination and as they do the DOWN shares may move quickly toward $50. I am not predicting future Index levels, but if prices continue to fall at their recent rate of about 18%, the Index will reach its lower limit in early 2011.

No position in UMM or DMM. I am long some homebuilder stocks.