A Sustained Rebound Ahead for Homebuilders?

Recently released housing market data have shown some meaningful improvements, with both the new- and existing-home markets gaining strength simultaneously. Reports have shown nice increases in builder sentiment, housing starts, and existing-home sales, with data also coming in above expectations and housing start data from the previous month being revised upward.

This story has been very different from the way the housing market has looked over the past year. Previously, the housing market has shown a marked divide in its behavior: periods where new-home sales (or starts) did better and periods where existing-home sales did better. It's been rare for both to exhibit the same behavior. Most recently, that trend has broken, with strong performance both from new-home activity and existing-home sales. In addition, homebuilder confidence grew in August for the third straight month.

What has been driving this rosy housing news? Morningstar's analysts see a confluence of factors, including lower mortgage rates, moderating home-price increases, and generally easier lending conditions.

Looking ahead, we are taking a positive view toward the housing market, with an expectation of continued moderate growth in the sector.

Investors who believe that more good news is ahead for homebuilders might consider a sector-specific ETF devoted to the homebuilding industry.  iShares US Home Construction (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 64% of the fund's total assets), this fund also holds building-materials and fixtures producers (20%), home-improvement retailers (12%), and furniture companies (4%). This fund contains 36 companies and is top-heavy: The top-10 holdings account for almost 62% of total assets.

Homebuilding companies are not high-quality firms. 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 25.7% compared with 13.1% for the S&P 500.

Fundamental View
After a historic rebound, the housing industry has seen some choppiness in 2013 and in the first quarter of 2014. The rebound has been fueled by near record-low mortgage rates, falling unemployment, and tight inventories. Demand for multifamily housing has helped to drive the housing recovery as well, with multifamily housing starts now back to 2007 levels (and running at 97% of prerecession highs). Single-family homes are at just 34% of the last high, so new-home demand still hasn't come back much.

Interest-rate jitters hampered housing companies' share prices in 2013, relative to the broader market, after dramatic gains in 2012. While the sector has rebounded some over the past month, the homebuilding sector (as measured by ITB's share performance) remains negative for the year. The recent strong data and lower mortgage rates suggest that investors have grown a bit less concerned about interest-rate hikes. Though we don't feel comfortable making an explicit call on interest rates, we're confident that interest rates at some point will rise. Investors in homebuilding ETFs 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. The rebound could be affected by anything from deteriorating macroeconomic conditions to a sudden jump in financing costs for homebuyers.

Many of the large homebuilders have aggressively reduced inventory and ratcheted back on developments. As a result, they 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 36 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 36 companies in the fund, 15 are homebuilders. Aside from homebuilders (which account for almost 64% of total assets), this fund also holds building-materials and fixtures producers (20%), home-improvement retailers (12%), and furniture companies (4%). 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) (2.1%). This fund is fairly top-heavy; the top 10 holdings account for almost 62% of its total assets.

Fees
ITB's 0.43% annual management fee is slightly higher than  SPDR S&P Homebuilders (XHB), a similar ETF that charges 0.35%. ITB's estimated holding cost is 0.47%.

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, in 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 more than 17 times greater.

Despite these differences, the performance of XHB and ITB was 95% 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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