Know What's in Your ETFs

 | Nov 11, 2013 | 12:15 PM EST
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Exchange-traded funds are perhaps the most lucrative creation out of Wall Street in the past decade. Although ETFs were already around before, their popularity has ballooned in the past 10 years. As the name somewhat implies, ETFs are baskets of securities that trade freely on stock exchanges, just like a share of stock. Instead of owning one agricultural company, for example, you can own a basket of them via the Market Vectors Agribusiness ETF (MOO). These securities have made ownership of commodities accessible with just a click of mouse; notably, the rush into gold in the past several years was more accessible thanks to ETFs such as SPDR Gold Shares (GLD).

Not surprisingly, as investor appetite for ETFs grew, Wall Street obliged. You can now find an exchange-traded fund for almost every conceivable trade or position you desire. You can go long or short market indices, bet on industries, interest rates, countries, currencies, even specific segments within industries.

But to assume that ETFs will do as they say is not necessarily a slam-dunk. In fact, investors should assume otherwise and look very closely inside the ETF to understand how exactly it will behave. The SPDR S&P Homebuilders (XHB) is a good example. This ETF, as it's named, is typically used as a proxy for the homebuilding industry. Yet, XHB has been a very poor indicator of the housing industry. Annualized new home sales have dropped 60% since August 2006. One would surmise that XHB would be down a similar rate. In fact, XHB is trading slightly above the level it was in August. In this case, the difference has been pleasant for investors but the lesson is the same: Look closely inside an ETF to determine how it will correlate to its named mandate.

So what is inside the Homebuilders ETF? For starters, 29% of the S&P Homebuilders Select Industry Index tracked by the ETF consists of homebuilders. The other 71% is anything but homebuilder stocks. Nearly half, or 43%, of the index consists of housing-related retail stores like Home Depot (HD), Bed Bath & Beyond (BBBY), and Helen of Troy (HELE), which makes blow dryers, water filters and other home products. I go to Bed Bath & Beyond when I need things like trash bags, a kitchen gadget or bath towels. These retailers, except for Home Depot, can do quite well absent any growth in housing starts. Many of the names inside the XHB are leading stocks, those that will do well in anticipation of new housing starts. Armstrong World Industries (AWI), Whirlpool (WHR), and construction-material businesses all do well in anticipation of a housing rebound.

Looking inside your ETF should be as basic a discipline as evaluating a share of stock. Don't blindly assume that because an ETF is titled or positioned one way that that is precisely how it will behave in the market. Often times, the positive or negative correlation you expect to obtain is a far cry from what the ETF's components will allow.

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