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Parsing the Industrials Landscape in ETFs

There is a small number of high-quality industrials-sector ETFs from which to choose.

Robert Goldsborough, 07/16/2010

Even as the exchange-traded fund market continues to mature, industrials-sector ETF offerings remain remarkably scarce relative to other sectors. While we believe tactical investors would benefit from seeing ETF providers further slice and dice the sector--for instance, in our book, an ETF with pure exposure to firms that make machinery would be a great addition to the space, because it would give investors a fund more tightly tethered to the ups and downs of the global economy--there remain several attractive options out there right now for investors. We would caution that, for most investors, such niche funds are rarely an appropriate choice. An industrials-sector ETF would be most appropriate as a satellite portion of a diversified equity portfolio only for those investors with a high-conviction thesis related to the space.

Investing in cyclical names at the right time can be very rewarding for investors, as cyclical stocks tend to outperform the broader market at certain times in the cycle. And sector ETFs can be a great way to play a recovery, because they allow investors to avoid single-stock risk and benefit from overall, industrywide trends. Recently posted economic data show promising signs of recovery that bode well for investors in the industrials sector: Manufacturing activity has steadily increased, companies have rebuilt inventories, and exports have grown. Obviously, it remains early in the economic recovery, and the risk of a double-dip recession cannot be discounted. At the same time, assuming that the recovery continues, industrials names may well be the place to be for the next 12 to 18 months. Certainly for the first half of 2010, the industrials sector enjoyed significant outperformance relative to the S&P 500.

The granddaddy of all industrials-sector ETFs--in terms of its assets, liquidity, and duration of existence--is the Industrial Select Sector SPDR XLI, which was rolled out in 1998. With more than 90% of its holdings in large industrial companies that are deemed to have economic moats, which Morningstar's equity analysts define as having durable competitive advantages, the Industrial Select Sector SPDR has the lowest expense ratio (0.21%) of all industrials-sector ETFs and is one of the most concentrated ETFs in the space (57 names) owing to its status as a market capitalization-weighted fund. In fact, fully half of the fund's assets are invested in just 10 companies. Investors also should keep in mind, however, that the Industrial Select Sector SPDR has a heavy exposure to General Electric GE (11% of fund assets) and its significant nonindustrial businesses as well as to the less cyclical aerospace and defense companies such as Boeing BA and Lockheed Martin LMT. Aerospace companies generally lag the broader industrials cycle because airplane orders are made years in advance of delivery, while defense spending understandably is more sensitive to government spending than to the macroeconomy. Also, the Industrial Select Sector SPDR offers investors some exposure to rapidly growing overseas markets, because many of its holdings have significant non-U.S. sales, although investors should be cautioned that the ETF holds no foreign companies. Finally, XLI does not hold any steel or materials companies; investors seeking those kinds of exposure would do well to consider ETFs in those spaces.

Two other, more-diversified industrials-sector ETFs that might hold some appeal for investors are Vanguard Industrials ETF VIS and iShares Dow Jones US Industrial Sector Index IYJ. Both are far less liquid than the Industrial Select Sector SPDR, and both are more expensive (VIS has a 0.25% expense ratio, while IYJ charges 0.48%). And like the Industrial Select Sector SPDR, both funds hold General Electric and have large stakes in the aerospace and defense industry while not holding any overseas firms, steel companies, or names in the materials sector.PAGEBREAK

For investors seeking some foreign industrials-sector exposure, two ETFs, neither of which is all that liquid, could fit the bill: iShares S&P Global Industrials Sector Index EXI and SPDR S&P International Industrial Sector IPN. The iShares offering holds about 185 industrials stocks, half of which are U.S. companies and half of which are based outside the U.S.; like its domestic peers VIS and IYJ, the iShares S&P Global Industrials Sector Index owns aerospace and defense names and also has a large holding in General Electric. The all-foreign IPN, by comparison, consists of 147 holdings based entirely outside the U.S. As a result, IPN has no holdings overlap whatsoever with the Industrial Select Sector SPDR, meaning that IPN and XLI are complementary ETFs, with regard to holdings. EXI charges 0.48%, while IPN charges 0.50%.

Even rarer than industrials-sector ETFs, however, are ETFs focused solely on the industrials sector's transportation subsector. Relatively speaking, the broadest-based transportation ETF--and the only one with any meaningful amount of liquidity--is the iShares Dow Jones Transportation Average IYT, which owns about 20 of the U.S.' largest, most-liquid transportation stocks. Holdings are price-weighted and include four rail companies such as Union Pacific UNP and Norfolk Southern NSC, three trucking firms such as C.H. Robinson Worldwide CHRW, and three delivery services players, FedEx Corporation FDX, United Parcel Service UPS, and Expeditors International of Washington EXPD. At 0.47%, IYT is an attractively priced way to play the space, although as is the case with the broader industrials-sector ETFs above, IYT is composed solely of U.S. transportation companies and offers investors little access to global infrastructure growth or transportation trends involving emerging markets or even developed non-U.S. markets. Few other transportation ETFs are available to investors, all offering far less liquidity than IYT. Claymore Shipping SEA, which has close to half of its holdings traded on non-U.S. stock exchanges, offers investors exposure to 30 firms that generate at least 80% of their profits from maritime shipping and charges 0.65%. PowerShares Global Progressive Transportation PTRP invests in an amalgamation of 40 companies believed to benefit from a societal transition toward cleaner, cheaper, and more-efficient transportation and charges 0.75%. And Claymore/NYSE Arca Airline FAA holds 24 U.S. and foreign airlines and charges 0.65%.

We continue to be believers in the idea of creating a pure machinery ETF, which would be designed to exclude the less cyclical aerospace and defense exposure in most industrials-sector ETFs and which also would omit companies with large financing arms and therefore no pure machinery exposure.

Beyond machinery, some other possible ETFs in the space spring to mind. In the transportation world, given the railroad industry's improved physical plants, recent attainment of the status of being able to cover its cost of capital, and increased on-time performance, we (along with Warren Buffett) see the rail space as a great way to play the U.S. economy in general and a recovery more specifically, through increased demand for coal for power generation, for containerized imports from Asia, and for ethanol-related traffic of corn, ethanol, and byproducts. Could an ETF provider construct a rail-only ETF? The answer is yes, which is somewhat surprising considering the massive rail-industry consolidation over the last four decades. IYT currently holds only the four largest publicly traded U.S. railroads: Union Pacific, Norfolk Southern, CSX CSX, and Kansas City Southern KSU. However, without much difficulty, an ETF provider could construct a concentrated ETF of 20 or so rail names by including the two large Canadian railroads,Canadian National Railway CNI and Canadian Pacific Railway CP, and a host of smaller-cap names in the short-line world such as Genesee & Wyoming GWR and RailAmerica RA, in the intermodal shipping space such as Pacer International PACR, and in the rail-car and locomotive manufacturing, leasing, and refurbishing subindustry such as GATX Corporation GMT, American Railcar Industries ARII, Trinity Industries TRN, and Greenbrier Companies GBX. An ETF provider now could even add Caterpillar CAT to this list, given that CAT recently has become a rail-industry player through its purchases of Progress Rail Services and Electro-Motive.

Also in the transportation world, the dynamics that make the idea of a railroad ETF compelling also could spur the creation of a trucking-only ETF, composed of truckmakers such as Navistar NAV and PACCAR PCAR, surface truck transportation companies such as J.B. Hunt JBHT and Con-way CNW, and logistics companies such as C.H. Robinson Worldwide and Landstar System LSTR.

Robert Goldsborough is an ETF analyst with Morningstar.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), Claymore Securities, First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.

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