RISK Magazine

February 2001

Shiller Backs Private Hedging Product

By Gallagher Polyn

An economic research firm backed by Yale University Professor Robert Shiller, author of one of last year's best-sellers, Irrational Exuberance, is developing a product it says will allow people to hedge their stock portfolios, the market value of their houses and the threat of unemployment or other fluctuations in their income.

Macro Securities Research, a subsidiary of Cambridge, Massachusetts-based Case

Shiller Weiss, says it is discussing with a number of banks issuing the first version of its product, called "Macro Securities," which could be based on equity markets, as well as other asset types. According to its creators, Shiller and the firm’s co-founder, Allan Weiss, this will offer the ease of trading a stock with the hedging benefits of a derivative. It expects to issue the first Macro before the end of the year.

Patented by Shiller and Weiss in 1999, Macros work by offering investors shares in long and short positions on an underlying index. Instead of investing the funds in the underlying, they are deposited in two cash accounts, one representing a long position and one an offsetting short tied to the underlying index via total return swaps. Funds are transferred between the two accounts depending on movements in the underlying. The accounts are themselves invested in liquid assets, such as Treasuries, and yield investors a return on those in addition to capital gains on the Macro position and the underlying asset's dividend stream. "The return is higher on a Macro [than on the underlying], under nearly all circumstances," says Weiss.

Macro short positions (as well as long positions) are expected to qualify for advantageous long-term capital gains tax treatment. (Normal short positions do not qualify.) The structure's other benefits flow from its "qualitative" aspects, says Weiss. Macro short shares, which require no margin, would resemble assets, so institutional investors and funds barred from using derivatives could use Macros for their shorting needs. The cost of shorting would itself be lower because with every issuance of a long Macro, a complementing short Macro would be created. This feature cuts out the transactional steps, and hence cost, currently required to short even highly liquid markets such as Nasdaq, he says.

Weiss says the Macro should appeal to retail investors in a bear market, who, as a group, are unlikely to turn to "user-unfriendly" derivatives. "From the investor’s perspective, the Macro is not a derivative -- there's no margin call, there’s no credit risk, you don't have to be an accredited investor, you can call your ordinary stockbroker up to buy it."

The firm is approaching large investment banks to act as Macro market makers, for which they would earn transaction fees. Profit-making opportunities from trading may also appeal to banks, though arbitrage, at least in Macros based n liquid markets, may be limited. Unlike stocks, Macros are designed to insulate an investor’s position from the effects of speculation leaving the investor exposed only to adverse movement in their initial investment’s position on the underlying.

Some basics still need to be ironed out, particularly the pricing mechanism.

Shiller says: "The problem is, when you ask people if they're interested in it, they say, ‘At what price?’ That's exactly what we can't tell them with any confidence because there's no market for it."

One equity derivatives specialist thought it was unlikely that the product could provide advantages that hedging strategies using currently available instruments cannot. However, even if other tools are available for equity hedging, that market is only a first step for the product, its developers argue. Their ultimate aim is to make liquid markets in currently illiquid economic interests such as national income, unemployment rates and homeowner real estate, none of which currently can be hedged.

Shiller says that, after corporate profits, more than 90% of US aggregate income is sensitive to sectoral, occupational and geographic uncertainty, which leaves open a gigantic market for risk sharing. He was first struck by the need for markets in more economic interests in the mid-1980s, when he observed the capricious effect of a booming housing market in the northeastern US, which, though benefiting property owners who bought early, such as Shiller, compelled many younger families to buy before they were fully ready to do so, only to strand them when the market tumbled.

In 1990, Shiller joined economist Karl Case, and Weiss, a former MBA student of Shiller's at Yale, to develop a real estate futures market. Their efforts got as far as a Chicago Board of Trade press release in 1993 announcing the development launch of a home equity insurance market, but the venture never took off.

"It's kind of bizarre," says Shiller, "We have futures markets for some very unimportant things, like pork bellies, but we don't have them for real estate, which is a major asset category."

Recently, Shiller has been proposing global income risk-sharing markets in which citizens, already defacto long their own country, could hedge their income risk by going short their domestic national income. For diversification benefits, investors could go long in foreign global income-sharing securities.

Shiller says he recently brought up the idea at the Chicago Mercantile Exchange. "I didn't-get a big reaction," he recalls. "We haven't really been optimistic that the futures exchanges are ready to try something like this."