New Housing MacroShares UMM and DMM ETF's

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If all goes well, this Monday, May 18th, MacroShares UMM and DMM should begin trading. There has been and still is alot of confusion on how these work and how they will trade so I will try to summarize how these will work.

Quick intro, and then following is the much more detailed explanation:

• UMM will trade 3 times leverage what the Case-Shiller housing index does on a cumulative basis.
• DMM will trade -3 times leverage what the Case-Shiller housing index does on a cumulative basis, inverse to UMM.

Why should you care about MacroMarkets UMM and DMM?

With the inception of these ETF's or ETP's(exchange traded products) as they would like them to be called, for the first time ever, there will be an exchange tradable fund (product) that will allow one to invest and short the U.S. housing market. As I discussed in a previous post, as much as you may want to or think you have invested in the housing market via previous real estate ETF's or mutual funds, you really have not.

So simply put, let's say you think the housing market will fall another 20% in the next few years. You could buy some DMM (the inverse), and if you are right, make 60% on your money (minus expenses, etc.). This is an opportunity simply unavailable to the common investor before Monday.

How do MacroShares work?

Unlike a typical mutual fund or exchange traded fund (ETF) which buys the underlying securities in various ways to create an ETF that follows a specific basket of securities, MacroShares are very different. Here is a breakdown:

1. At inception, two trusts are created which contain the cash from the IPO. One trust represents the UMM and the other trust represents the DMM.
2. The shares of UMM and DMM are paired such that there will be an equal number of shares of each at inception.
3. These two trusts have a binding agreement to pledge the assests of one to the other depending upon a predetermined formula which is related to the Case Shiller.
4. The formula is the cumulative % change in the Case Shiller since the inception (reference Case Shiller index level of 162.17, the value for Dec-08) times 3.

Here is my graphic of how it works adapting from MacroShares' graphic:

Looks simple so what is the catch? There has to be a catch, right?

So yes there is a catch, in fact there are a few. There also are some neat benefits. Here are some of the details:

1. UMM and DMM are 3x leveraged ETF's, but the gain you can make is capped at 100% gain. Why? Well if you look at the above, what happens when the Case Shiller has moved down 34%? 34% x 3 = 102% so we just transfer 102% of UMM to DMM. Oops, can't do that. So in that case according to the prospectus UMM goes to zero and DMM doubles and they close out both trusts and end the deal. (but they plan to issue more on a rolling basis in the future).
2. The expense ratio is 1.25% which ain't cheap but in my opinion it ain't bad either to have the opportunity to invest long or short in the housing market. And...
3. The cash sitting in the trusts will be invested in T-bills and other instruments so if that makes interest over the expense ratio then it will be paid out quarterly as income to UMM and DMM share holders (proportional to the value of UMM and DMM at that time depending on where the Case Shiller is).
4. Unlike other leveraged ETF's which are based on 2x or 3x daily movements and over time can veer from tracking the underlying, these UMM and DMM MacroShares' value tracks 3x the cumulative change in the underlying (Case-Shiller) over the whole time since inception.
5. Technically, the trust agreement is to be settled in November, 2014 at the value of the cumulative move of Case-Shiller at that time from the inception value. See next for more on this point which I personally think has been misinterpreted.

So what about this November 2014 settlement date thing?

I think this has been much misinterpreted although who knows I could be wrong and we won't know for sure until this starts trading. Here is a quote from a recent SeekingAlpha post on UMM and DMM:

Where should UMM and DMM trade between now and November 2014?

Simple: They should trade based on where investors expect the index to be on Aug. 31, 2014.It's really that simple. It's like a futures contract: Everything that happens between now and expiration is mostly irrelevant.

So, while I agree in theory, by contract what matters is what the Case-Shiller will be on Aug. 31, 2014, I think in reality in the market that is not all that matters! Take the last sentence: "It's like a futures contract: Everything between now and expiration is mostly irrelevant." First of all it may be like a futures contract but it isn't in many respects. But even if it was a futures contract, how do long term futures contracts trade? Here is a plot of corn futures from futuresource.com for two different contract dates (the green bars are for the near contract of May 2009, and the blue line is for the Dec 2011 contract which is more than two years away):

So is the blue line which is a contact for 2 years away trading like everything now is irrelevant? absolutely not. Now if you look at the scales you will see there is an offset between the two which represents any expectations of the future price being higher than now and the time value of a binding contract to buy and sell corn in the future. But the key is the way futures trade is always relative to the underlying now. If folks think corn will be higher than now in 2 years, but then now goes up, generally they expect the future to still be higher by the same amount which is now a higher absolute number so the long term futures contract goes up and down with the spot price.

There will be premiums and discounts to the current value based on the Case Shiller but the key point is that we should expect UMM and DMM to trade in the short term with movements in the Case Shiller. If the Case Shiller goes down 10% in the next year, then UMM should trade down about 30% and DMM should trade up about 30%. The spread between that true value calculation and what they actually trade at will fluctuate even daily even though the Case Shiller will only change monthly. That spread will represent changes in expectations for the future on various time scales.

So we will see how they really trade over the next few months to year but I believe they will track the Case Shiller for the most part on a 3x leverage and inverse 3x leverage. So if you think you know where the Case Shiller is going over the next few months or years, then you have the opportunity to trade that with UMM and DMM.

My next post (next post is up now) on this topic will be to examine how one could use UMM and DMM to hedge the typical household's most common big purchase and largest capital investment - their home. This is where these new ETF's (oh yea ETP's) get even more interesting.

Note: For more background if you haven't already, here are my previous posts leading up to this on the Case Shiller.

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