Want To Buy A Sector Fund? Ignore the Label; Examine the Contents

Thursday, February 25, 2010

After reading yesterday’s write-up (Homebuilder Stock Articles Raise Questions – And Exclamations), you understood why a 9% year-to-date return for homebuilder stocks was more appropriate than 21%. Still, 9% in less than two months is pretty good. So, you checked the performance of your homebuilder fund and… WHOA! What happened? The performance is so much lower. There must be a mistake.

Well, there is, but not in the performance calculations. Rather, it’s in the fund’s name. You thought it meant one thing, but it actually meant another. The label doesn’t match the contents, and here’s why…

The “pure” homebuilding industry is composed primarily of residential construction companies. These are the ones we think of: Pulte, NVR and the others shown in the table below. Typically included are manufactured housing companies, although they are few – four in the table. In total, the list is 21 companies. However, many are quite small, with only seven having a market capitalization of $1 billion or more.

Now put yourself in a fund manager’s shoes. Investing in such a narrow industry that is also highly cyclical is risky to both the investors’ performance and the fund management company’s business (performance losses can drive investors away). The solution? Broaden the industry definition by bringing in tangential companies like manufacturers of paint, rugs, windows, etc. Also, retailers like Home Depot and Lowe’s. In varying amounts, that is what each of the three main specialty funds has done.

The table shows the “pure” industry holdings, then what and how much is owned by each of the funds. (ETF means exchange-traded fund.)

  • iShares Dow Jones US Home Construction Index Fund (ITB) (ETF with $314 million in assets) mirrors the Dow Jones US Home Construction Index
  • SPDR S&P Homebuilders ETF (XHB) (ETF with $675 million) mirrors the S&P Homebuilders Select Industry Index
  • Fidelity Select Construction and Housing Portfolio (FSHOX) (Mutual fund with $92 million) is an actively managed fund whose holdings and allocations can vary. Fidelity does compare its performance to an index: MSCI Custom U.S. IM Construction & Housing 25/50 Index

Note that the more each fund differs from the true homebuilder industry, the wider the performance shortfall for this year, so far. That is not to criticize the fund’s management. Rather, it highlights how investors’ expectations from a fund’s name can go unmet.

So, clearly we cannot rely on the fund label. We must take a careful look at its contents to ensure we are getting the portfolio we want.

By the way, in early 2001, funds had to meet a more stringent SEC test to prevent a mismatch of fund name and holdings (rule 35d-1, if you’re curious). It raised the minimum percentage of portfolio holdings matching the fund name from 65% to 80%. The funds above would all seem to fail the test. Their relying on an index name is not an excuse. However, for us, that is neither here nor there. These seeming glitches occur frequently enough that we must do our own analysis and double-checking.

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John Tobey on Seeking Alpha

Seeking Alpha Certified

February 2010