Finding the Best Exposure in Homebuilding ETFs

Homebuilding ETFs are making it much too easy for new investors to make the biggest mistake of them all: taking an ETF’s name at face value.

While there are three ETFs that claim to give investors to homebuilding, the stocks these funds hold and the proportions in which they hold them varies dramatically:

1. SPDR Homebuilders ETF (XHB) – This SPDR fund holds 35 companies, but few are pure-plays on the actual business of pumping out the next subdivision. The leading holding of the portfolio, Tempur-Pedic International (TPX) has little to no exposure to homebuilding. Looking further down the list of top 10 positions, this fund also includes retailing names like Lumber Liquidators Holdings Inc (LL), and manufacturers like Owens-Corning, Inc. (OC), which have some exposure to homebuilding, but certainly are not home builders. Pier1 Imports also shows up as a fairly large constituent in this ETF. The fund’s holdings have an average price to earnings ratio of just under 20, due to the mix of pure-plays and derivative businesses.
2. Dow Jones U.S. Home Construction Index (ITB) – This fund of 29 holdings has perhaps the best exposure of any to American residential housing construction. The fund’s top three holdings include a nearly double-digit position in PulteGroup Inc (PHM), Lennar Corporation (LEN), and DR Horton Inc (DHI), all of which are exposed to the whims of residential real estate development. The fund holds only two retailers in the top 10 – Home Depot (HD) and Lowe’s (LOW), and each make up fewer than 4% of the fund. This fund’s holdings trade at a premium to other ETFs because it has such a concentrated approach to direct plays in real estate development. As a whole, the fund trades at nearly 23 times expected forward earnings.
3. PowerShares Dynamic Building & Construction (PKB) – PowerShares built a solid fund of 30 diversified homebuilding-related companies when it set out to create the PKB ETF. The fund keeps index constituents to just under 5% of the total investment portfolio, choosing stocks based on a culmination of fundamental factors including valuation, growth and other factors in its proprietary screens. For what it’s worth, PowerShares’ fund has beaten the index it seeks to beat with screening. Powershares’ reliance on valuations to make selections makes this the cheapest on an expected earnings basis, trading at only 17 times forward earnings estimates.

Comparing Performance

In the last year, all homebuilding ETFs have solidly beaten the returns of the broad market thanks to an improving real estate sector, faster home sales, and a gradual rise in housing starts.

US Housing Starts data by YCharts

Not surprisingly, the five-year returns of these three homebuilding ETFs is aligned with their portfolio weightings. Because SPDR Homebuilders ETF (XHB) is less concentrated on homebuilding stocks, it beat the two other funds over the last five years. However, in just the past 1-year period, the fastest riser was Dow Jones U.S. Home Construction Index (ITB), which is the purest play on the actual pace of homebuilding and the business of constructing homes. The fund logged impressive 57% returns for investors who invested one year ago today.

Investors who want homebuilding stocks with some downside protection from other less cyclical industries would favor XHB or PKB over the ITB fund. Investors who want quick and dirty positioning in the companies that build homes should look no further than the Dow Home Construction Index (ITB).  Another play on a commercial real estate boom with much higher yields would be real estate investment trusts (here’s a comprehensive list of REITs by Name and Ticker) or their REIT ETF equivalents.

As a cyclical play, the real estate trade does look crowded. One has to consider how, over the long term, these companies can return cash to shareholders in the form of dividends, repurchases, or continued book value growth. Over history, the homebuilding industry has been wildly cyclical, and if one believes that we are at a midpoint in a real estate recovery, the industry as a whole looks fairly valued. The upside experienced by the industry today will certainly be met with another future lull in housing and profitability for homebuilders.

Disclosure: No positions in any ETFs or stocks highlighted in this article.