Commentary

The idea was hailed by many as a watershed event; Time Magazine went so far as to name the idea one of 2008's Best Inventions. However, just three months after their launch, we are asking if and when investors will start buying MacroShares housing ETFs.

Time lauded the funds for their democratization of housing as an asset class. And this isn't some obscure asset class like baseball cards--residential housing has a capital value of roughly $20 trillion, 2 times larger than the U.S. stock market. Besides owning residential properties directly, the best way to gain exposure to housing was through futures and options contracts traded on the Chicago Mercantile Exchange, but everyday retail investors could not make the high minimum investments for these products. Alternatively, exchange-traded products break down bigger minimum investments into smaller individual shares, making ETFs one of the easiest vehicles investors can use to pick up their desired investment exposure. By putting housing into an ETF, individuals could finally get housing exposure with far greater liquidity, lower transaction costs, and lower non-systemic risk than by purchasing brick and mortar abodes directly.

So now that the products are here, where are the investors? In just over three months, MacroShares Major Metro Housing Up and MacroShares Major Metro Housing Down have attracted only $25 million in assets combined. Granted, three months is hardly long enough to judge the viability of a product, but these funds have thus far generated far more press than dollars.

Perhaps investors are not comfortable enough yet to add these products to their mix. Many portfolio building tools haven't considered housing as an asset class, so the risk, return, and correlation data may have not yet been considered. Or, possibly, there are already too many "alternative" investment options available (commodities, hedge fund strategies, and currencies all come to mind) with which to become comfortable, so potential investors are staying with the tried-and-true mix of stocks and bonds.

For investors who think about their investment portfolios in a holistic manner, along with the present value of expect expenses over one's life, these funds may have so far just been overlooked. Many people often tinker with their asset allocations to the point that they feel 70% stock exposure is too great relative to bonds while 60% is too little, but they fail to account for a $400K home compared with a $500K investment portfolio. Or perhaps mental accounting will keep these assets entirely separate. Who knows?

To MacroShares' credit, as well as professor Robert Shiller of Case-Shiller Index fame, the product has esoteric appeal and justifiably good uses in a long-term portfolio. Shiller elaborates on these benefits in an SEC filing for the ETFs, but I will lay out the bulk of the case below.

Most people own a home or desire to do so one day, and the products can be used as hedging instruments as well as portfolio diversifiers. Potential home purchasers can use UMM to gain exposure to home prices until they find the property they desire, thus hedging in price changes until their life circumstances change. Existing homeowners often have more capital tied up in their homes than in their stock and bond portfolios, and they can gain a more palatable balance by purchasing DMM to offset their housing exposure. However, these funds also carry a degree of leverage and a couple other complications that investors should understand before jumping in.

How the Housing Funds Work
First and foremost, these are not exchange-traded funds in the traditional sense. They are exchange-traded products, but the funds themselves consist of nothing more than treasuries. This is in stark contrast to traditional ETFs, like SPDRs, that purchase a basket of stocks in the trust owned by ETF shareholders. Rather, MacroShares products transfer cash quarterly between two opposing funds based on the performance of the Case-Shiller Index. Therefore, whenever shares of UMM are created, an equal number of DMM shares must be created or the cash balance between the funds would not facilitate future transfers.

Another unique feature is that these funds have a finite lifetime. They are set to expire and liquidate on Nov. 25, 2014, and the liquidation value of the funds will be based on how much the Case-Shiller Index has changed from Dec.er 31, 2008, through Aug. 31, 2014. Because there is no arbitrage mechanism in these funds prior to expiration, the funds will act less like an index tracker and more like a prediction tool for where the index will be upon expiration. In this manner, the funds perform more like a futures contract than a traditional ETF. Furthermore, because there is no arbitrage mechanism in place, the funds will consistently trade at what would seem to be premiums and discounts to net asset values. However, the funds are not supposed to track the index on a day-to-day basis; they're looking forward to 2014.

For investors seeking longer-term exposure to housing price changes, MacroShares has a solution in the works. So long as interest in the funds is sufficient enough to make the products viable, the company intends to issue more housing ETFs with five-year maturities prior to the expiration of this fund. By doing so, investors will be able to reinvest their returned money from the liquidated fund into a new ETF, laddering their exposure to housing prices much as they would if they were building a bond portfolio.

The funds are 3 times leveraged to changes in Case-Shiller Index, but this is leverage in the traditional sense like a margin account, not in the "stay away because daily compounding will kill my returns" sense. Because the funds are leveraged to a base index value and never rebalance prior to expiration, the returns on the MacroShares ETFs should not decay relative to the underlying Case-Shiller Index due to volatility as other leveraged ETFs had done in the past.

Take note, however, that if the index moves by more than 33% before 2014, all the Treasury notes from one trust will be transferred to the other, and the funds will likely be liquidated. In fact, if the funds approach the 33% change threshold prior to expiration, they will likely exhibit some of the traits unique to options, such as convexity. While a 33% move over the course of five years is a low probability event, few people need to be reminded that housing prices have been more volatile over the past five years than they were in the prior 100 years. A 33% move in housing prices would not really shock anyone, and it would not be catastrophic either if MacroShares delivers on its intentions of issuing later-dated housing products allowing shareholders to reinvest their returned capital.

Another plus for the funds is that, because they hold Treasury notes, investors will receive interest income on their holdings. However, this is likely to be inconsequential for the near future due to the fees: Each fund charges 1.25% per year, which is very steep in the land of ETFs. Because ETF fees are directly deducted from the fund, creating a performance drag, an interesting point arises. If an investor is seeking to hedge away housing exposure, would they be better off buying the housing-down ETF (DMM), or should they simply short housing-up (UMM)?

Perhaps these funds simply raise too many questions for investors--another potential investment that has found itself in the "too hard" pile. Only time will tell.

Paul Justice, CFA does not own shares in any of the securities mentioned above.



Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), Claymore Securities, First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.