By including housing related exchange traded funds (ETFs) into a portfolio, an investor may mitigate the swings in the housing market that could potentially eat away at his or her wealth.
The MacroShares Housing report, A Missing Ingredient to an Optimal Portfolio, by Robert J. Shiller, reviewed the merits of adding MacroShares Major Metro Housing Down (DMM) or MacroShares Major Metro Housing Up (UMM) to optimize an investment portfolio by increasing risk adjusted returns.
Modern portfolio theory suggests that an investor should hold risky assets in the market portfolio by leveraging or deleveraging through less risky assets according to individual risk tolerance. It can be inferred that investors could hold real estate in any portfolio that is not exposed to real estate risk, but there are other facets to be considered before doing so.
- Most people invested in housing do so on leveraged basis since there are more than 15 million households considered to be in negative equity since the housing bubble collapsed.
- UMM and DMM securities were made to help mitigate such events by letting people hedge against these vacillations in the market.
- It should be noted that the securities are incorporated with a 3-to-1 leverage.
In an example, Shiller calculated that if the housing index were replaced with a simulated portfolio invested in UMM during January 1987, the ETF would have rebased to the index level each time the security matured or expired (which happens if its underlying value has doubled).
Shiller has calculated that with a tangency portfolio for a zero risk-free rate includes 57% stocks, 11% bonds and 32% housing. By including real estate in a portfolio of stocks and bonds, the improvement in the risk-return tradeoff is increased by almost 5% of standard deviation to the left. This shows the nearly zero, or in his sample, slightly negative, correlation between UMM and either stocks or bonds.