Industrials

With the Federal Reserve and the Treasury deliberately devaluing the dollar, US goods are cheaper for those abroad. Eventually this will unwind and create a headwind for exports.

Industrials remain vulnerable to the credit crunch, and many are hoarding cash rather than paying out dividends or buying back stock. Nonetheless, dividend yields remain respectable in the 2-3% range which makes them an attractive investment compared to currently low bond yields.

The most popular ETF with industrial in its name, DIAMONDS (AMEX: DIA), is not really a manufacturing play. The ubiquitous Dow Jones Industrials Index which it follows has shed heavy industry over its 116-year old history. Less than one-third of DIA remains in manufacturing firms known for hard goods.

Several less visible ETFs follow industrial manufacturing faithfully at low cost. For most long-term investors the obvious choice is either SPDR Industrial Select Sector ETF (AMEX:XLI) or Vanguard Industrials ETF (AMEX:VIS), each sporting annual fees under 0.25%. Another option is iShares Dow Jones U.S. Industrial Sector ETF (NYSEArca:IYJ) at 0.48% annual fees. Returns through Q3 2010 show that these three true industrials correlate highly with each other but not with DIA.

Today industrials are increasingly sophisticated manufacturers such as in aerospace, and activities such as steel production are now found in the basic materials sector. General Electric is the #1 holding in most industrials ETFs, with 10% holdings typical. Single company risk is dampened by GE's holding company strategy of aggregating unrelated companies. The funds all include names such as Caterpillar, 3M, Boeing and United Technologies. Transportation companies such as Union Pacific and United Parcel Service are lumped in with industrials for their use of heavy machinery.

There are three fundamental ETFs which attempt to beat the standard indexes:

• First Trust Industrials AlphaDEX ETF (AMEX:FXR); 0.7% annual fees
• Invesco PowerShares Dynamic Industrials Sector Portfolio ETF (AMEX: PRN); 0.6% fees

Historical data suggests that weighting with fundamental financial ratios can beat traditional market capitalization indexes before fees. Market capitalization is swayed by investor emotion, and there has been plenty of that in recent years. Fundamental ratios are a pure reflection of a company's performance. Unfortunately fundamental ETFs not only have to beat their benchmark rivals but must do so consistently by about 0.40%-0.50% to offset their higher fees. This is a tall order.

A more straightforward index variation comes from the Rydex S&P Equal Weight Industrials ETF (AMEX:RGI), with 0.5% fees. The effect of equal weighting is to dampen single company risk (ie., improve diversification) and to tilt exposure to smaller firms.

It might prove convenient to some investors, but they could easily allocate similarly by picking multiple industry sector ETFs at less annual expense.

In addition there are international industrials ETFs:

• iShares S&P Global Industrials ETF (NYSEArca:EXI); annual fees of 0.48%
• SPDR S&P International Industrial Sector ETF (AMEX:IPN); 0.5% fees

Finally, there are two leveraged ETFs, one double long and one double short. Needless to say they are are highly volatile and for traders only:

• ProShares Ultra Industrials ETF (AMEX:UXI); 0.95% annual fees
• ProShares UltraShort Industrials ETF (AMEX:SIJ); 0.95% fees