by Mike McDermott
ETFs can be excellent trading vehicles, giving broad industry or asset class exposure in a single trade. Essentially, an ETF is a basket of stocks or other securities that can be bought in a single transaction. There are two primary advantages when trading ETFs
- Immediate diversification (most of the time)
- Lower transaction costs compared to buying the basket of securities
But not all ETFs are created equal. Some ETFs have liquidity issues making it difficult to move even modest amounts of capital on a short-term basis. Others may be comprised of securities that are not directly tied to the expected focus of the fund. And at times, the holdings can be so concentrated that the ETF offers little in the way of practical diversification.
So when trading ETFs, it pays to know the details. Understanding how a particular ETF will react to different market scenarios puts a trader in a better position to succeed. A deeper understanding of the inner workings of individual ETFs allows not only for proper selection when setting up an individual trade, but also better conviction (positive or negative) when holding a position.
Understanding how an ETF is put together helps me to know how a trade will react in a particular situation. If a retail ETF is comprised of stocks selling to higher-income customers, I may be less likely to short this vehicle in an environment where the current great compression has squeezed the lower-income consumer, while more affluent consumers remain healthy.
Today, we’re going to look at two popular homebuilder ETFs. The SPDR S&P Homebuilders (NYSEARCA:XHB) and iShares DJ US Home Construction (BATS:ITB) securities sound like similar vehicles, but behind the scenes they operate from a very different perspective.
When I look at the US housing market, I’m typically focusing on the “shadow inventory” of homes likely to hit the market, the falling prices for both new and existing homes, and the lethargic level of activity on a nationwide basis.
We have looked at several vulnerable homebuilders as short candidates, and another option for taking advantage of the perennially weak sector may be to pick inflection points using popular homebuilder ETFs.
Starting with XHB, the good news is that there is plenty of diversification. The ETF is made up of 35 different stock positions, and the top 10 positions represent only 38% of the fund.
But looking a bit more closely at the individual positions, XHB looks much more like a retail ETF than a home building security. The top four positions in the fund are Williams-Sonoma (NYSE:WSM), Pier 1 Imports (NYSE:PIR), Tempur-Pedic Intl (NYSE:TPX), and Mohawk Industries (NYSE:MHK).
Only ONE of these names is even related to homebuilding. Of course new homes are usually furnished so the positions are related, but this is hardly a “homebuilder” ETF. Rounding out the top 10 positions, are Best Buy (NYSE:BBY), Pulte Homes (NYSE:PHM), Owens Corning (NYSE:OC), Leggett & Platt (NYSE:LEG), Whirlpool (NYSE:WHR) and Smith A O Corp. (NYSE:AOS). Of these positions, only PHM is a true homebuilder.
So if you’re looking for accurate exposure to the homebuilding industry, XHB is probably not the right vehicle. The positions are certainly related to homebuilding, but there are issues that affect retailers that may not be the same issues affecting the actual homebuilding industry.
Less Diversification, Better Construction
The iShares DJ US Home Construction (ITB) fund has a bit more focus when it comes to actual homebuilding companies. Looking at the top four positions, we have NVR Inc. (NYSE:NVR), D.R. Horton (NYSE:DHI), Lennar Corp. (NYSE:LEN), and Toll Brothers (NYSE:TOL).
All four of these positions are legitimate homebuilders. While the companies operate in different geographic regions, and are differentiated by quality and types of homes sold, they all actually build homes – a novel concept…
Notice the difference in the chart patterns (click on each to enlarge). Instead of the strong upward trend that we see in the XHB retail names, the actual homebuilders look much more vulnerable.
There are certainly reasons why home-related retailers are performing better than the actual homebuilders. Logically, it makes sense for homeowners to spend money improving their existing home. After all, if you’re stuck with a home that you can’t sell on the market, it makes sense to buy some nice flooring, a few curtains and a new mattress.
As a trader, if I want to make a bet (for or against) the homebuilding industry, I want to make sure that the vehicle that I choose actually tracks the industry that I am following.
Now ITB offers a bit less in terms of diversification… The top four positions account for roughly 29% of the fund’s assets, and the top 10 positions make up more than half of the portfolio composition. Low diversification means that if something out of the ordinary happens to any ONE company, it could have a larger effect on the ETF.
But even NVR (the largest ITB position) only represents 8.33% of assets – not enough to cause a major problem.
Liquidity Favors XHB
In terms of liquidity, XHB is by far the more favorable choice. Trading roughly 4.9 million shares a day, with a security price near $18.30, the average daily dollar volume is $90.3 million. That’s plenty of liquidity – even for large traders with hundreds of millions under management (assuming a manager isn’t going to bet the entire farm on this one trade…)
ITB only trades about 690,000 shares a day, and with a price near $13.30, that equates to a daily dollar volume of about $9.2 million. If you manage a shop with AUM of $100 million and want to take a 5% position in the ETF, you’re going to have difficulty putting your position on without significant slippage. But for most individual and niche prop traders, ITB has plenty of liquidity for active trading.
So while there are a few reasons XHB has developed a reputation for being the “go-to” ETF for homebuilders (primarily liquidity and diversification), ITB is likely the better choice for most traders looking for exposure to the US homebuilding market.
There’s a lot of action in this group right now, with significant opportunities for nimble traders. Hopefully this ETF scorecard information gives you some good ammunition for picking the right vehicle for capturing your profits.
Disclosure: As active traders, authors may have positions long or short in any securities mentioned. Full disclaimer can be found here.