(Editor's Note: The following is an edited excerpt of an article from December's edition of the Exchange-Traded Funds Report. Subscribers can read the full story here.)

Sometime in the next few months, MacroShares will launch its long-promised house-price exchange-traded funds. When they do, it could herald a new era for the ETF industry.

But not for the reason most people think.

The fact that the new housing Macros will allow retail investors to speculate on house prices for the first time ever is interesting, but it's not revolutionary. Savvy investors can already speculate on house prices using the Chicago Mercantile Exchange's house-price futures.

What's revolutionary about the new ETFs is how the products are being launched.

How The Funds Work

First, some basics. The new MacroShares Major Metro Housing Up (NYSE: UMM) and MacroShares Major Metro Housing Down (NYSE: DMM) ETFs are designed to deliver 300% of the return (up and down) of the S&P/Case-Shiller Composite 10 House Price Index, which measures the average price of a house in 10 major metropolitan markets.

The funds don't actually own houses, of course. The only asset they hold is Treasuries. They track the index by working like a teeter-totter: When house prices go up, assets are shifted from the Down Macro to the Up Macro, and vice versa. (As a result, the funds can only be offered in pairs, with equal numbers of Up and Down shares.) This unique structure is what allows the funds to track something like house prices, where there is no underlying asset.

It is important to understand, however, that the funds will not directly track the price of the index. The S&P Case-Shiller indexes are reported monthly with a two-month lag; that is, the June index price reflects house prices for the three months ending in April. The funds' net asset values will be based on this lagging index price.

Investors, however, will likely look forward when establishing the market price for the funds, using not just the index value but also expectations for where that value is heading. The funds will likely trade like a long-term future on housing prices, reflecting a bet on medium- to long-term trends in house-price movements.

The house-price ETFs will open up the largest single asset class in the U.S. to equity trading for the first time ever. In other words, the fact that these funds are launching is a big deal.

Still, for the ETF industry, the way the products are being launched could be even bigger.

Vanishing Seed Capital

Historically, ETF companies have relied on what's called "seed capital" to launch new ETFs. Specialists—professional market makers who are paid to ensure that ETFs trade in a liquid fashion—put up the initial money needed to create the first few shares of the ETF. Then, once trading begins, new shares are created on demand.

In the good old days—say, 1998–2004—specialists were happy to do this. In exchange for providing seed capital, they became designated market makers in an ETF, and were paid fees for handling trading volume. It was a lucrative business, and specialists curried favor with ETF companies by promising big amounts of seed capital. It was common for funds to launch with $10 million, $25 million or even $50 million in seed funding.

But something happened after 2004 that caused seed capital to dry up. A variety of explanations have been offered: smaller spreads, new regulations, fewer blockbuster products, etc. For whatever reason, specialists became very reluctant to seed new ETFs. This has gotten worse recently, as the credit crisis has put an extra premium on cash.

Investors are feeling the fallout in a number of ways. For one, several funds have failed to launch this year, simply because they couldn't find seed capital; other launches have been delayed. And even those funds that have launched have done so with the absolute bare minimum of assets—typically just $2.5 million or so. Data show that funds with fewer assets tend to have wider spreads, and the spreads on these new ETFs have been significant.

It's a nasty feedback cycle. The lack of seed capital stifles innovation among ETF issuers, so fewer new funds come to market. Those funds that do come to market have high spreads, which makes it hard for them to attract assets. Because new funds aren't attracting assets, specialists are reluctant to commit seed capital in the future.

It's a big problem for the ETF industry, and MacroShares thinks it may have the solution.

The MacroShares Model

MacroShares is planning to launch its new house-price ETFs using a unique "open IPO" process. Rather than having specialists provide seed capital, MacroShares will allow broker-dealers—any broker-dealer who registers with MacroShares—to sell shares directly to investors prior to the launch. Those underwriters will be compensated in two ways:

1. Investors will be charged a per-share commission of 0.4% to 1.8% depending on the number of shares sold, which will be paid to the broker-dealer.

2. Broker-dealers will receive a pro-rata portion of the total expenses paid to the fund forever.

It remains to be seen if the MacroShares program will work. The IPO was originally supposed to run from Nov. 3–Nov. 17. That was postponed "due to market conditions," and some wondered if there simply wasn't enough demand. MacroShares’ Chief Executive Sam Masucci shrugged that off, telling ETFR that it saw demand for $250 million–$500 million.

The latest indication, according to a recent IU.com interview with the company, is that the auction’s excepted to come sometime in April. But Masucci cautioned that such a rough estimate was tied to the SEC’s giving the funds a green light. (See related story here.)

But at a time when many ETFs are struggling to find any seed capital at all, the MacroShares approach at least offers an interesting alternative.