New Derivatives Allow For Unique Market Exposure

Includes: ICF, IYR
by: Richard Kang

No analysis today. Just a reference to this article from the GARP (Global Association of Risk Professionals) website regarding real estate related risks.

For those looking to hedge real estate “beta” the best you could do today is some combination of derivatives, for example property derivatives out of the UK and Case-Shiller housing futures in the US, as well as maybe some of the real estate/REIT ETFs. Currently, the real estate ETF area is actually quite thin, especially considering the heavy bias towards REITs. The same can be said of real estate derivatives which have been around for a while but not in great numbers. This will change soon according to this:

That is one reason why real estate derivative markets — the lynchpins for hedging — are almost here, he exclaims. He goes on to list a number of indices either in the development or planning stages by such groups as National Council of Real Estate Investment and Fiduciaries, Standard & Poor’s (residential and commercial), and Real Capital Analytics, and for particular markets or sectors such the IPD Index for London, a new hotel index and Hong Kong real estate index.

“Everyone and their grandfather and sister will have an index,” laughs Edelstein, “so there will be plenty of opportunities for hedging.” On the buy side, the derivatives potential comes from demand by pension funds and other institutional investors, foreign investors, REITs, portfolio investors and even hedge funds. On the sell side, lenders, institutional owners, CDO (collateralized debt obligation) and CMBS (commercial mortgage-backed securities) managers as well as hedge funds, speculators and REITs can derive some benefit from derivatives.

And the reason for all this interest in real estate investment hedging? Answers Edelstein, “there is more risk now than there was five years ago.”

More risk? Clearly. I’ve shown many charts in the past few months and the concept of new highs is something that we haven’t seen in such amounts since the top in late 1999, early 2000. Today, we again can see this on a price chart of any real estate related ETF versus the broad market indices, except in Canada and a small number of regions.

Getting back to product development we can see that, just like the ETF industry, this shows that the derivatives markets are continuing to branch out in the global marketplace. Depending on your point of view, this will appear as expansion to narrower and unnecessary niches or more unique and interesting niches . Another example is in the area of timber, and here’s this notice also from GARP about derivatives for wood pulp.

You could say this is an offshoot of timber, but it could of course fit somewhere in the broader commodity complex. It’s interesting how, despite being perceived as fully saturated by many, the beta industry continues to punch out new products. A recent posting of mine regarding new metal ETC offerings from ETF Securities conforms with this.

Many industry participants in the ETF space may not be aware of what is happening in the derivatives industry. For example, not only can you get exposures to various interest rates through futures contracts but you can also get exposure to inflation. There’s a multi-faceted inflation-indexed fixed income play in there and that’s a fairly typical global macro trading strategy.

Bottom line: There is a big push of new products in the derivatives industry under way globally and its momentum began earlier than that of the ETF industry. It’s not getting a lot of attention except in certain parts of the institutional world. I don’t think it’s as big (or certainly, as well publicized) as the ETF industry but it is unfortunately getting the attention of many naysayers with crystal balls forecasting some impending doom. Derivatives, hedge funds … and even ETFs. They spell doom! Hardly. If the risk is in the use of leverage, that’s the one and only true risk. However, just like Amaranth (the biggest and worst case we’ve seen thus far), we’ll always have participants on the other side of the trade. Regulation will likely be increased over time with greater international cooperation from the regulatory community. However, it’s the market and its broad array of participants who I believe will keep things in relative equilibrium.

For me, derivatives play an essential role for many market participants. For some who see them as market exposures to have on the long side, perhaps even with certain levels of leverage, that’s fine. But others see them also as hedging instruments to offset unwanted exposures. In today’s world where hedge fund investments cross over to any and all other asset classes, it’s key for these managers to have the appropriate tools to properly control and maintain the adequate level of “beta” they require. It’s not an easy task, but without these new instruments, “difficult” is an understatement.

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