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On this previous post I introduced the new MacroShares Major Metro Housing ETF's UMM and DMM which are designed to track 3 times leverage of the Case-Shiller 10 city housing index. It has been mentioned that these new ETF's will allow homeowners and others interested in the housing market to hedge their interests.
So how can you use DMM to hedge a home purchase?
DMM will theoretically trade 3 times inverse what the Case-Shiller 10-City housing index does over time (see the previous post for my thoughts on whether that will in fact occur). So if we assume that will happen, and we assume that I buy a house in area that follows the Case-Shiller 10 city index very closely then we can examine how this hedge would work. To make a perfect hedge we would buy shares of DMM worth 1/3 of our home value. This illustrates how that would work out in bad housing market where home prices drop after I buy my house:
So in that scenario, my home value and the Case-Shiller drop 20%, but since I own 1/3 of my home value in DMM, it goes up 60% and exactly offsets my losses in my home value. So in this case I have perfectly hedged my home against losses in value in a bad market.
What if the housing market goes up instead of down with this exact same hedge strategy?:
So in this case, my home value goes up 20%. However, the value of my DMM goes down 60% so at the end I am perfectly even as in the above bad housing market example.
So you may say, well that sucks, the housing market went up but I did not net any money. Absolutely, but the purpose of a hedge is to reduce or eliminate future uncertainty in value and to do that in this case, you had to also give up the opportunity to make money.
One important point about these ETF's specifically. They are capped at a 100% gain or loss. So the degree to which they can hedge is capped at a point where housing prices move 33.3% up or down.
But what if my local housing market doesn't really track exactly with the Case Shiller 10-city composite?
You are not alone, no local housing market exactly tracks with the Case Shiller 10-city composite. The following graph shows all 20 cities that the Case Shiller tracks:
You will notice that individual metro areas don't exactly track the 10-city composite. In general, there are some that are hotter like Los Angeles and go up and down further than the 10-city composite. And then there are some that are much calmer like Denver and Atlanta. So here is how I would adjust the above hedging strategy for those cases:
- Calmer housing markets: you would invest less than 1/3 of the home value in DMM. For example if a housing market like Atlanta goes up about half as fast as the 10-city composite then you would invest 1/2 of 1/3 or 1/6 of the home value to get the same even hedge.
- Hotter housing markets: you would invest more than 1/3 of the home value in DMM.
If you really wanted to do this, it would be important to adjust the invested amount depending on the volatility of the local market related to the 10-city index. If you didn't then you could end up losing more money than if you had done no hedge at all according to which direction the market moved.
Other variations and hedging ideas using UMM and DMM:
- If you wanted to only do a partial hedge to protect you from some downside but not all you would simply invest less in DMM than the 1/3. This would also be appropriate if you felt more strongly that the housing market was going to go up but you wanted some partial hedge protection.
- The opposite hedging idea would be if you had cash for say a down payment on a house but you really didn't want to buy yet but you were worried that the housing market was going to go up over the next few years while you wait and maybe price you out of the home you would want. You could put some (1/3 if you wanted to just keep up with the appreciation) of the down payment in UMM which will go up if the housing market goes up and your down payment will grow with it.
- If you are a home builder and you have a long term contract to build a bunch of houses at a set price today but you are concerned that as you build these over the next few years home prices will go up and you will lose margins as that happens. In this case you could buy some UMM with some of your capital to make it grow with the housing market.
- If you are a home builder who just built a house and trying to sell it but the housing market is weakening and prices are dropping. You want to hold the selling price to not lose your profit but you are afraid it might take a year to sell in which case prices might drop even further. You could buy some DMM which would hedge against that potential drop in prices.
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