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ETF Specialist

Which Homebuilder ETFs are Well Constructed?

There are important differences between the two principal homebuilder ETFs.

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While home prices have stabilized since April 2009, they have shown little to nothing in the way of any kind of upturn since that time. And although the end of federal government support for the homebuilding industry--in the form of the June 30 discontinuance of the $8,000 first-time-homebuyer tax credit and the government concluding more than $1 trillion in government purchases of mortgage-backed securities in March--has not been followed by a step down in housing prices, the sector at best has shown tepidness. Indeed, while the Standard & Poor's/Case-Shiller Home Price Indices data released in late July showed that the annual growth rates of home prices improved in May compared with April, index officials hastened to add that we have been in a strong seasonal period for home prices. They also noted that there might have been some "residual impact" from the homebuyer-tax-credit program, given that it covered any new home purchase closing through June 30.

And with continued high unemployment and a generally declining stock market (leading to feelings of a negative wealth effect among consumers), new home sales have been choppy at best, with little evidence of a sustained recovery. For example, the U.S. Department of Commerce in late June reported that new home sales in May had fallen almost one third from April to a seasonally adjusted annual rate of 300,000, far below economists' estimates. After revising that May number to 267,000, the Commerce Department in late July reported a complete reversal, with new home sales increasing 23.6% in June to a seasonally adjusted annual rate of 330,000. And while the June number exceeded the 310,000 economists had forecasted, it was hardly worthy of a champagne toast, given that it still represented the second-slowest monthly sales pace since Commerce officials first started tracking such data in 1963. At this point, head fakes seem the norm, with the housing market still seemingly unable to string together consecutive rosy numbers.

Despite this bleak macroeconomic picture, investors shouldn't ignore several positive aspects of the homebuilding sector as they look for signs of recovery. Clearly there has been an industrywide shakeup, with some of the sketchier companies going belly up and many of the larger players now sitting on piles of cash. The major homebuilders also are much leaner and better-run organizations than they were a few years ago, having aggressively reduced inventory, ratcheted back on developments, and downsized their organizations to better align their cost structures for a lower-demand environment. The expectation is that the public homebuilding players will be better positioned for the next housing upturn.

For investors with a strong level of conviction--either pro or con--regarding the prospects for the homebuilding industry, there are several suitable ETFs. As always, we caution investors that such a fund works best as a satellite holding in a diversified equity portfolio, given what concentrated bets homebuilding ETFs are on a very narrow segment of the market. We also remind investors that, despite the differences between the two principal homebuilder ETFs out there, their returns remain highly correlated (98%).

However, investors should pay close attention to the important differences between the two principal homebuilder ETFs when considering whether to invest.

The larger and more liquid of the major homebuilder ETFs is  SPDR S&P Homebuilders ETF (XHB). The fund tracks the S&P Homebuilders Select Industry Index, which is composed of the homebuilding subindustry portion of the S&P Total Market Index and contains 25 homebuilders, including  Ryland Group (RYL),  MDC Holdings (MDC), and  D.R. Horton (DHI); building-products manufacturers such as Armstrong World Industries (AWI),  Masco (MAS),  Mohawk (MHK), and Leggett & Platt (LEG); home-furnishing companies and retailers such as  Williams-Sonoma (WSM) and  Bed Bath & Beyond (BBBY); and home-improvement retailers including  Home Depot (HD) and  Lowe's Companies  (LOW). The direct housing-market exposure offered by XHB is surprisingly low--just 32% of the fund's assets are invested in companies that construct housing. However, the remaining holdings all are tied to the housing market in one way or another, and housing-industry sentiment in the stock market clearly has been shown to affect the performance of these names. XHB's expense ratio of 0.35% is the cheapest in the homebuilder ETF space, and is reasonable, in our opinion.

Perhaps even more intriguing for investors--and generally counterintuitive, given the pain in the housing industry--is that XHB actually outperformed the S&P 500 in 2008 (albeit slightly), 2009, and the first half of 2010, owing to strength in the nonhomebuilding portion of the SPDR's portfolio.

Meanwhile,  iShares Dow Jones U.S. Home Construction Index Fund ETF (ITB), which tracks the Dow Jones U.S. Select Home Construction Index, is more of a pure play when it comes to direct exposure to U.S. homebuilding companies. Here, homebuilders such as  NVR  (NVR), D.R. Horton, and  PulteGroup (PHM) account for about 64% of total assets, and holdings in nonhomebuilding companies like Home Depot are limited to no more than 40% of the portfolio, ensuring that--for now, at least--investors are certain to receive a significant amount of direct housing-industry exposure in this ETF. ITB contains 26 companies and charges a slightly higher fee of 0.48%. Reflecting its portfolio's higher weighting toward homebuilding companies--which have underperformed the broader market in recent periods--the iShares offering underperformed the S&P 500 in 2008 and (albeit slightly) in 2009, and narrowly outpaced the broad benchmark in the first half of 2010.

Robert Goldsborough does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.