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ETF Specialist

A Targeted Way to Home in on Housing

This ETF holds mostly homebuilders but includes some housing-related subsectors as well.

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Investors seeking exposure to the housing sector can consider the sector-specific exchange-traded fund  iShares U.S. Home Construction (ITB). This ETF holds stocks across the market-cap spectrum and defines the homebuilding segment broadly to include companies from other industries, such as building products, home furnishings, and home-improvement retailers. Because this ETF is a concentrated bet on a very narrow segment of the market, this fund is suitable only as a complementary satellite holding in a diversified portfolio. The housing sector is highly cyclical and sensitive to economic and credit conditions.

The homebuilders segment accounts for almost 63% of ITB's total assets and is this ETF's biggest industry weighting. Other significant weightings include building-materials and fixtures producers (15.8%), home-improvement retailers (9.6%), and furniture companies (4.3%). This fund contains 41 companies and is top-heavy, with the top 10 holdings accounting for 63% of total assets. With an average market cap of $6.7 billion, this fund has a mid-cap tilt.

ITB is also a volatile fund. During the past five years, it has had a standard deviation of 23.2% compared with 11.9% for the S&P 500.

Fundamental View
Thus far in 2015, housing stocks have performed well. New home sales hit a seven-year high in the summer, while existing home sales have been mostly strong, with year-over-year increases for 12 consecutive months through September 2015. Housing starts also neared an eight-year high over the summer.

On balance, Morningstar's equity analysts take a positive view toward the sector; they expect continued moderate growth and a midcycle (2019) estimate of 750,000 industry housing sales, in line with the 40-year average. Some clear conditions are in place for the sector to continue its strong performance, including still-tight inventories, rosy employment trends, growth in the household formation rate, and cheap credit. Areas of concern include discouraging housing-start data, sooner-than-expected interest-rate hikes, weak jobs data, and housing prices outstripping wage gains.

Homebuilding companies are highly cyclical investments. This industry has very 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 other subsectors found in this ETF are adjacent to the homebuilding industry and are also very cyclical.

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 be volatile. And rebounds could be stifled by anything from deteriorating macroeconomic conditions to a sudden jump in financing costs for homebuyers.

Many large homebuilders have replenished their land banks. Most homebuilders who survived the downturn are now standing on more-stable financial ground. From a cost standpoint, the prices for land, labor, and materials have all shot up significantly since the housing downturn, which along with tight existing and new home supply, have caused significant appreciation in the new home price market.

To gain a better picture of the health of the homebuilding industry, one can monitor a broad range of data points. However, investor sentiment usually moves long before the data affects 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. Investors also closely watch the National Association of Realtors reports on sales of previously occupied homes, as they provide insight into supplies of existing homes. When fewer existing homes are available, demand for new homes often rises.

Portfolio Construction
This fund aims to replicate the performance of the Dow Jones U.S. Select Home Construction Index. The index contains 41 companies, and holdings are float-adjusted and market-cap-weighted. However, total holdings in nonhomebuilding companies are capped at a maximum of 40% of the portfolio.

Out of 41 companies in the fund, 17 are homebuilders. Aside from homebuilders (which account for almost 63% of total assets), this fund also holds building-materials and fixtures producers (15.8%), home-improvement retailers (9.6%), and furniture companies (4.3%). The largest nonhomebuilding holdings are home-improvement retailers  Home Depot (HD) (5.2%) and  Lowe's (LOW) (3.8%) and building-materials manufacturers  Sherwin-Williams (SHW) (2.5%) and  Masco (MAS) (2.0%). This fund is fairly top-heavy, with the top 10 holdings accounting for 63% of total assets. The average market cap of a company in ITB is $6.7 billion.

This fund's 0.43% annual management fee is slightly higher than  SPDR S&P Homebuilders ETF (XHB), which is a similar ETF. XHB charges 0.35%.

There are only two ETFs with meaningful exposure to the housing sector: ITB (0.43% expense ratio) and XHB (0.35%). ITB has much higher exposure to homebuilders because of its index construction rules, with homebuilders making up about 63% of its assets. XHB, meanwhile, devotes only about 33% of its assets to homebuilding companies. ITB's index caps its total weighting to nonhomebuilding companies at 40%, while XHB's index tracks a much broader universe.

In terms of portfolio structure, the two funds differ 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 nonhomebuilding companies to 40%. As a result, a nonhomebuilding retail giant like Home Depot makes up less than half the weighting in ITB as homebuilder  D.R. Horton (DHI), even though Home Depot's market cap is more than 14 times that of D.R. Horton.

Despite these differences, the performance of XHB and ITB has been 94% correlated during the past five years. Also, both funds have tracked their respective indexes reasonably well since inception. However, XHB's portfolio has exhibited lower volatility.

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