Friday, April 6, 2007

Looking for a Short Play in Real Estate with ETFs

Back in December, when problems in the real estate market were beginning to hit the news, I wrote a post about the situation and pointed out that if you wanted exposure to real estate in your portfolio, REITs were the place to be and homebuilders were to be avoided.

Since that time, the news from the real estate sector has gotten both worse and more publicized. Having written another post on using inverse sector funds, I find that many searches to the TradeRadar blog are looking for simple ways to use the concept to play the problems in real estate via ETFs.

It would seem that the two places where real estate would have the most impact would be real estate ETFs, obviously, and financial ETFs.

Zeroing in on homebuilders, there is the SPDR Homebuilders ETF (XHB) which, since early February, has been enduring a bumpy ride downward with a few blips up every time some pundit proclaims we have seen the bottom. Is there an inverse ETF that corresponds to this one? Unfortunately no.

Expanding our horizons somewhat, we can look at the real estate ETFs like the iShares US Real Estate ETF (IYR), the iShares Cohen & Steers Realty Majors Index (ICF), the streetTracks Wilshire REIT Index (RWR) and the Vanguard REIT Vipers (VNQ). There are inverse ETFs that move in the opposite direction such as the ProShares UltraShort Real Estate ETF (SRS). At first glance, it would seem that holding SRS would have paid off over the last few months. Once again the answer is no. ETFs like IYR, ICF, et al. primarily hold REITs and the majority or REITs are not focused on mortgages but are oriented toward commercial property. These REITs have taken a hit like the overall market since late February but since then have held up fairly well and regained much of what was lost.

Next up are the financials. When mortgages go bad, banks feel the pain. What ETFs hold banks and is there an inverse fund we can buy? There are two well known ETFs that track financials, the iShares Dow Jones Financial Sector ETF (IYF) and the S&P Financial Sector SPDR (XLF) and one that tracks banks, the streetTRACKS Bank ETF (KBW). Here again ProShares offers an inverse ETF, the UltraShort Financials (SKF). Would an investor have benefited by buying SKF in the last few months? The answer here is a qualified yes. There have been some wild swings in SKF but if you had bought in February when the fund started trading and held through today you would be up around 10%. XHB, however, has fallen 17% during that time so the inverse sector ETF has not captured as much of the price action as might have been expected. Looking at the core holdings of IYF and XLF, for example, it is clear that mortgages, and especially sub-prime mortgages, make up only a small part of the overall portfolios of the underlying companies in these ETFs. The financials may be impacted by real estate but their performance is not as tied to real estate as much as to interest rates, merger activity and the state of the overall economy.

What conclusions can be drawn? One, it is imperative that investors understand the holdings of any ETF they consider investing in. It is true that using ETFs an investor can take a diversified position in an industry sector and profit from an industry specific trend. Most ETFs, however, are skewed toward the largest participants in an industry. Be sure that the trend you are hoping to profit from will truly impact those holdings in the selected ETF.

The other conclusion is that that the real estate mess is not yet spilling over into the general economy. If we can't find significant impact in the ETFs most closely associated with real estate then we are probably not going to see real estate as the cause of the next recession.

Finally, using various shorting strategies with XHB since the beginning of February would have yielded the best return. Directly shorting the ETF or using options would both have produced winning trades. Unfortunately, these are not the easiest techniques for the individual investor but I'm sure the marketing departments at the major ETF vendors are cooking something up as we speak.



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