Homebuilders and the Fed: An ETF for Investors Seeking Housing-Sector Exposure

Following the surprise news that the Federal Reserve will continue with its easy-money policy and not taper its bond-buying program, interest rates fell across the board on Wednesday, with rates reversing some of their recent rises and the 30-year mortgage rate settling in around 4.5%, or 10 basis points less than it had been a week earlier. Since May, the 30-year mortgage rate has risen more than 100 basis points, and mortgage rates still are much higher from their all-time lows earlier this year. Still, Wednesday's news from the Fed was great news for the equity markets, with the S&P 500 Index rising 1.2% on Wednesday. And it was better news still for the housing sector, with the housing-oriented exchange-traded fund  iShares U.S. Home Construction ETF (ITB) rallying close to 5% on Wednesday. That was a nice lift for the housing sector, which surged in 2012 but has been under pressure in recent months. Homebuilders could move further in either direction given that several important indicators of the health of the housing market are due out next week, including the latest read on the Case-Shiller index and several earnings reports from publicly traded homebuilders.

Investors who believe that more good news is ahead for homebuilders might consider a sector-specific ETF devoted to the homebuilding industry. ITB has the greatest exposure to the housing sector. Because ITB is a concentrated bet on a very narrow segment of the market, we view this fund as a tactical investment, suitable only as a complementary satellite holding in a diversified portfolio. Investors should take note that the housing sector is highly cyclical and sensitive to employment and credit conditions.

Aside from homebuilders (which account for about 62% of the fund's total assets), this fund also holds building-materials and fixtures producers (20%), home-improvement retailers (13%), and furniture companies (4.5%). This fund contains 32 companies and is top-heavy, with the top 10 holdings accounting for almost 61% of total assets.

Homebuilding companies are not high-quality investments. This industry has low barriers to entry, and many firms hold significant land banks on their balance sheets, which can tie up large amounts of capital for long periods of time. The cyclical nature of this sector makes it an unattractive long-term holding.

Unsurprisingly, ITB is a volatile fund. During the past five years, it has had an average standard deviation of returns of 35.8% compared with 18.5% for the S&P 500.

Fundamental View
The housing industry has continued what has been a historic rebound, continuing to post largely favorable data as buyer enthusiasm has returned. Fueled by near record-low mortgage rates, falling unemployment, and tight inventories, the housing industry's recent growth has made homebuilders bullish. In the spring of 2013, housing starts hit nearly a five-year high, reaching a pace of 1.04 million starts on an annual basis. And in September 2013, the National Association of Home Builders/Wells Fargo Home Builder Sentiment Index was at 58, meaningfully above the 52 it had registered in June 2013 and dramatically above the 44 that was recorded in May 2013. At 58, that's the index's highest level since November 2005, at the height of the housing market's boom. (Readings above 50 mean that more homebuilders consider market conditions to be favorable than poor.) Homebuilding companies came under serious pressure in mid-2013 from interest-rate jitters, but the Fed's recent decision to continue with its monetary stimulus has calmed investors for now. Still, investors should take note that this sector already has given back some of what had been an impressive run; this ETF surged more than 78% in 2012, but for the year to date it's down more than 2% (as the S&P 500 Index has risen 16%).

Regardless of whether the homebuilding sector has gotten ahead of itself, investors should pay close attention to market sentiment, as homebuilding companies often move well in advance of fundamental data. Investors also should recognize that the industry can create volatile and unrewarding financial performance for many participants. And a rollover of the housing market's rebound stands as the gravest risk to all homebuilders. That could be caused by anything from deteriorating macroeconomic conditions to a sudden jump in financing costs for homebuyers.

At the company level, by aggressively reducing inventory and ratcheting back on developments, many of the large homebuilders are now sitting on piles of cash despite the heavy losses they've taken in recent years. They also have downsized their organizations to better align their cost structures for a lower-demand environment. During the past few years of weakness, many private homebuilding companies have gone bust, and even the stronger publicly traded firms have written off half or more of their book equity since the peak. But the homebuilders that survived are now standing on more stable financial ground.

To gain a better picture of the health of the industry, one can monitor a broad range of data points. However, changes in many of these data points drive investor sentiment long before their impact shows up in homebuilders' financial statements. Among these data points are the monthly NAHB/Wells Fargo Housing Market Index (which measures builder sentiment), the U.S. Census Bureau's monthly new-home sales reports, regular reports on new housing starts, and the Standard & Poor's/Case-Shiller index of home prices in 20 major U.S. cities. Also, the National Association of Realtors reports on sales of previously occupied homes can be important data points for the housing sector, as they provide insight into supplies of existing homes. Fewer existing homes available can translate into greater demand for new homes.

Portfolio Construction
ITB aims to replicate the performance of the Dow Jones U.S. Select Home Construction Index. The index contains 32 companies, and holdings are float-adjusted and market-cap-weighted. However, total holdings in non-homebuilding companies are capped at a maximum of 40% of the portfolio. Out of 32 companies in the fund, 14 are homebuilders. Aside from homebuilders (which account for about 62% of total assets), this fund also holds building-materials and fixtures producers (20%), home-improvement retailers (13%), and furniture companies (4.5%). The largest non-homebuilding holdings are home-improvement retailers  Home Depot (HD) (5%) and  Lowe's (LOW) (4%) and building materials manufacturers  Sherwin-Williams (SHW) (2.7%) and Mohawk (MHK) (2.6%). This fund is fairly top-heavy; the top 10 holdings account for more than 62% of total assets.

Fees
This fund's 0.46% annual management fee is slightly higher than  SPDR S&P Homebuilders (XHB), a similar ETF. XHB charges 0.35%, while ITB's estimated holding cost is 0.48%.

Alternatives
There are only two ETFs with meaningful exposure to the housing sector: ITB and XHB. ITB has a much higher exposure to homebuilders because of its index construction rules, with homebuilders making up about 62% of its assets. XHB, meanwhile, devotes only about 26% of its assets to homebuilding companies. ITB's index caps its total weight to non-homebuilding companies at 40%, while XHB's index tracks a much broader universe.

In terms of portfolio structure, the two funds differ a bit as well. XHB tracks an adjusted equal-weighted index, so companies of all sizes sit shoulder to shoulder. ITB, by contrast, tracks the float-adjusted, market-cap-weighted Dow Jones U.S. Select Home Construction Index, which caps non-homebuilding companies at 40%. As a result, a non-homebuilding retail giant like Home Depot makes up a little more than half the weighting in ITB as homebuilder  PulteGroup (PHM), even though Home Depot's market cap is 16 times that of PulteGroup.

Despite these differences, the performance of XHB and ITB is 97% correlated over the past five years. Plus, both funds have tracked their respective indexes reasonably well since inception. ITB has greater volatility than XHB, however, so investors in ITB should monitor their investment closely.

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