Institutions might move into residential housing

Pension funds and money managers will soon be able to tap into the $22 billion residential housing market.

Goldman, Sachs & Co., New York, last month announced the firm will soon roll out new instruments including forwards and total-return swaps that will enable institutions to take bets on the direction of housing prices in 10 major metropolitan markets from Boston to San Francisco.

At $22.2 billion as of March 31, the U.S. housing market is one-third bigger than the domestic equity market, valued at $16.4 billion, and approaches the size of the $25.9 billion U.S. bond market, according to Goldman data.

There has been no good way of investing in that market short of buying actual properties, said Rajiv Kamilla, a vice president in Goldman's structured products group. Goldman primarily will rely on housing indexes marketed by MacroMarkets LLC, Madison, N.J., in designing its derivative instruments.

"Housing has low volatility and high returns relative to other asset classes," said Sam Masucci, chief executive officer of MacroMarkets, which licenses financial applications of the S&P/Case-Shiller Home Price indexes.

Those indexes were developed in the 1980s by Karl Case, an economics professor at Wellesley College, Wellesley, Mass., and Robert Shiller, an economist at Yale University, New Haven, Conn., and author of "Irrational Exuberance," the well-known book about the late 1990s tech-stock bubble.

MacroMarkets is negotiating to license the indexes to other dealers. Mr. Masucci declined to name the firms.

The Chicago Mercantile Exchange launched futures and options based on the indexes in May, but volume has been low, with total open interest of 1,536 contracts of as Oct. 11. Mary Haffenberg, a CME spokesperson, said the contracts were geared for individuals, not institutional investors, and it takes awhile to educate potential investors in a new product.

The CME contracts also have maturities of up to only 13 months, which is less useful for institutional investors.

In contrast, the Goldman contracts will have maturities up to five years. Pension funds and endowments, which could use the contracts to help hedge against inflation, likely will seek contracts of four to five years in maturity, Mr. Kamilla said.

The contracts provide a new investment opportunity.

Sally Yu, a portfolio manager with Barclays Global Investors, San Francisco, said the giant money manager might use the contracts in new and existing investment strategies. She said the contracts can be used to obtain exposure to the housing market, hedge portfolio exposures and make relative-value plays between different sectors.

Mr. Masucci said his firm is also negotiating with unidentified firms that plan to launch index-linked notes and exchange-traded funds based on the housing indexes. The firm is also in discussions with mutual fund managers that might launch commingled funds based on the regional housing market indexes, he said.

Mr. Masucci said managers also could create long-short housing funds. For example, investors could go long on Chicago and short on San Francisco

Mr. Shiller, who is also MacroMarkets' co-founder and chief economist, said he hopes retirement plans will invest in the contracts.

"The big mistake individuals are making is putting so much wealth in their own homes," the Yale University economist said in an interview.

Mr. Shiller said he would like defined contribution plans, and possibly defined benefit plans, to offer participants a way of offsetting this risk. In addition, he hopes some managers will create housing bear funds, akin to existing stock bear funds that permit investors to bet on a falling equity market.

For pension funds, the instruments offer a new way to tap into a major market that has strong historic returns, high Sharpe ratios and low correlations with other asset classes.

Over five- and 10-year periods ended March 31, housing outperformed a variety of assets classes, although it lagged real estate investment trust stocks. For example, housing returned 14.1% annually during the five-year period, dwarfing returns of domestic stocks and government bonds, at 2.5% and 4.9%, respectively.

For the year ended March 31, housing returned 13.9%, while stocks returned 8.7% and government bonds returned 2.6%. Commodities — also a good hedge against inflation — returned 17.8% for the same period, while REIT stocks returned 30.1%.

Correlations to other asset classes also are extremely low. In the period from Jan. 3, 1995, to March 1, 2006, housing had a -40.5% correlation with U.S. stocks. Housing's strongest correlation was with commodities, at 22.3%.

Goldman plans to launch forward contracts, where investors can make relatively straightforward bets on the direction of various housing markets. The securities firm will also issue total returns swaps, which are commonly used in structured finance. In those swaps, a total rate of return payer pays the purchaser index performance in exchange for a fixed funding rate.

Down the road, Goldman expects next-generation products will customize exposure to housing through options, floors and caps, leveraged and unleveraged products, and funded notes.