Two Homebuilder ETFs, Two Very Different Returns

Could 2014 be the year for homebuilder ETFs? They’ve bounced back after lagging the S&P 500 last year, with the Bloomberg Americas Home Builders Index up 8%in the past month, double the S&P 500′s gain.

The surge started in mid-December when the Fed said it would start tapering bond purchases by $10 billion a month. That was viewed as a sign that the economy is improving and that interest rates will stay at least moderately low. In addition, average job growth in markets served by public homebuilders is growing 2.2%, faster than the 1.6% job growth for the overall economy, a favorable demand indicator, according to Bloomberg Industries’ Drew Reading. The two big homebuilder ETFs that investors have to choose from vary greatly, however, in the industry exposure they provide and the returns they generate.

The choice is between the iShares U.S. Home Construction ETF (ITB) and the SPDR S&P Homebuilders ETF (XHB). Both have plenty of liquidity and reasonable expense ratios. Where they part is in their definition of “homebuilding.” Is it erecting a structure that people will live in? Or is it erecting a structure and then furnishing it with couches, a fridge, bath towels, perhaps a hot tub?

Pure Play

If you’re in the more conservative camp, the iShares product tracks companies that actually produce wood and put up walls, for the most part. Its portfolio has 65% in home builders and 15% in building materials companies, according to data compiled by Bloomberg. Companies like Lennar Corp. (LEN) and Toll Brothers Inc. (TOL) are among top holdings, and ITB has more than 9% of assets in each. The ETF’s fairly narrow focus makes it sensitive to changes in the housing market.

If you’re in the camp that uses a more liberal definition of homebuilding — one that includes that hot tub — then the SPDR Homebuilders ETF (that’s XHB) may be a better fit. It has only 30% in home builders and 20% in building materials companies. Twenty percent is in retail companies like Bed Bath & Beyond Inc. (BBBY), Pier 1 Imports Inc. (PIR) and Lowe’s Cos. Inc. (LOW). Another 15% is in home furnishing companies like La-Z-Boy Inc. (LZB) and Whirlpool Corp. (WHR).

A recent article in Bloomberg Businessweek noted an intriguing difference between new home sales and XHB’s price with two great charts. A big reason for the divergence is the ETF’s extra exposure to those retail companies, which collectively were up over 30% in the past year. In addition, XHB weights all of its holdings equally so that small- and mid-cap companies, which have been doing better than large-cap stocks since 2012, have a louder voice than they do in ITB, which is market-cap weighted. The top 10 holdings in ITB make up 63% of the portfolio.

The unique aspects of ITB work against it in some market environments, which explains why the performance gap between the two ETFs can be very different. The SPDR ETF trounced iShares’ fund in 2013 with a return of 25% to ITB’s 18%. But the iShares owned 2012, beating all U.S. ETFs with a 75% return to XHB’s 53% gain. Looking at the 5-year returns, XHB is up 126% to ITB’s 86%. During the housing crisis between 2007-2008 they declined together for the most part with XHB having an edge, down 66% while ITB fell 75%.

Here’s a look at returns for the iShares U.S. Home Construction ETF (ITB) and SPDR S&P Homebuilders ETF (XHB):

ITB / XHB