Hedging the Housing Bubble?

October 18, 2005

With houses staying on the market longer and interest rates creeping up, it’s time to think about hedging against the housing bubble. Here’s how – with indexes, ETFs and other instruments.
The drumbeat about the housing bubble grows louder every day.  Houses that used to sell in days are staying on the market for weeks and months; interest rates are creeping up, and the Federal Reserve shows no signs of stopping; a Google search for "Housing Bubble" comes up with nearly 3 million hits.

What's a smart investor to do?  Hedge, of course. The eggheads at the indexing houses have been busy at work devising dozens of ways to hedge against any "pop" in the housing bubble.  From exchange-traded funds (ETFs) to housing options to structured products, there's a diversity of options available.  Here's a look at the options:

Sell and Rent

The simplest approach is to sell your house and rent another one nearby.  Of course, there's the hassle and expense of moving; the absurd six percent realtor's fee; the loss of the rental expense; and the loss of the mortgage interest deduction.

But rent increases have trailed property prices dramatically in recent years: In San Francisco, rents are up just 18 percent over the past five years, while housing prices are up 65 percent.( )  You might be able to trade up!

Still, boxing up the china isn't everyone's idea of a good time.  And fortunately, there are alternatives.

Short an ETF

One of the easiest things to do would be to short one of the four, highly liquid REIT exchange-traded funds (ETFs).  All of these funds provide diversified exposure to the U.S. real estate market, with office, residential and industrial holdings. While that may not be the perfect hedge for your house - the residential and commercial markets do not always track one another - you can be sure that these funds will respond to any "bursting" of the housing bubble. 

The iShares Cohen and Steers Realty Majors Index Fund (ICF) is the largest of the bunch, with assets of almost $1.5 billion. It's also the most concentrated, at just 31 names, and it has a firm large-cap bias.  Components are chosen by committee, and are capped at eight percent of the total portfolio value.

For those looking for more diversified exposure, the iShares Dow Jones Real Estate Index Fund (IYR) may do the trick.  The float-adjusted index covers a broad sample of the U.S. real estate industry, and features 85 names, with a much larger sampling of small and mid cap REITs

The streetTracks Wilshire REIT Index Fund (RWR) from State Street Global Advisors (SSgA) does IYR one better: it features 92 different REITs, with a sampling of office, residential, hotel, storage and industrial names.  In other words, it covers the whole kit and caboodle.  It also offers a lower expense ratio (0.26% vs. 0.60%) and a much higher yield. (4.79% vs. 3.7%). 

The Vanguard fund - which tracks the MSCI REIT index - boasts the lowest expense ratio of the bunch (0.12%), as well as the most diversity (110 names).  On the flip side, it sports the lowest yield of any of the four funds, at just 3.48%.   Still, it's diversified, float-adjusted structure has helped VNQ posted a 25.68% compounding three-year return, second-highest among the ETFs.  It's worth noting that the VIPERs are a share class of the much larger Vanguard REIT fund, which boasts over $7 billion in assets.

Among the four, the true passive investor would probably shy away from ICF, which operates on a committee model and does not feature small and mid-cap holdings.  But we're looking for a hedge here - a short - so those negatives can be seen as a good thing.  If the ETF market turns sour, the concentrated nature of ICF could pay off.

One major downside to hedging these ETFs is that, by shorting the funds, you take responsibility for paying the dividend. Given the large yield on these funds, that could run into a substantial chunk of money.

Name

Ticker

Assets ($millions)

# of Holdings

ER

Distribution Yield

3-Yr Return

iShares Cohen and Steers Realty Majors Index Fund

ICF

$1,455

31

0.35%

3.70%

21.50%

iShares Dow Jones U.S. Real Estate Index Fund

IYR

$808

85

0.60%

3.81%

19.50%

streetTracks Wilshire REIT Index Fund

RWR

$735

92

0.26%

4.79%

26.63%

Vanguard REIT VIPERs (MSCI REIT Index)

VNQ

$347

110

0.12%

3.48%

25.68%*

* Denotes index performance; share class has only been trading for one year.  The VIPERs have in the past - and will likely in the future - trail the index by a small margin.

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