Industrials ETFs: Beyond the Dow

Monday, December 15, 2008

For most investors, "industrials" brings to mind the Dow Jones Industrials Index. In reality industrial manufacturing firms producing finished goods represent less than 20% of this index. The popular DIAMONDS (AMEX: DIA) which follows it serves various purposes, but exposure to true industrials is not one of them.

Happily there are low-cost ETFs which follow industrial manufacturing faithfully. For most long-term investors we recommend SPDR Industrial Select Sector ETF (AMEX:XLI) at annual fees of 0.24% and Vanguard Industrials ETF (AMEX:VIS) with annual fees of 0.25% . A pricier alternative is iShares Dow Jones U.S. Industrial Sector ETF (NYSEArca:IYJ) at 0.48% annual fees. These three correlate highly:

Industrials used to mean steel mills, but today they are more likely to be sophisticated manufactured goods producers (basic materials being a better sector to find raw industrial production). All three pure industrials ETFs in the chart above listed General Electric as the #1 holding in 2008. VIS held over 20% of assets in GE at one point, perhaps more than seems sensible in a diversified index. The funds all include names such as Caterpillar, 3M, Boeing and United Technologies. Aerospace/defense is an important part of industrials. We question the prominence of United Parcel Service, a top 10 holding for all. Since when is a logistical services company industrial? UPS has more in common with Wal-Mart than Caterpillar. We prefer a less expansive, more manufacturing-oriented definition.

Sector overweighting tease out extra returns by emphasizing certain aspects of an economy over others. But few sectors depart dramatically from major indexes, and industrials are no exception as can be seen in the above graph which also contains SPDR 500 (AMEX:SPY) tracking the S&P 500 and DIA tracking the Dow Industrials. It would be a mistake to say that SPY correlates well and DIA less well with industrials just because of where they end up after 3 years. A look back into middle years shows fairly random variation between SPY, DIA and the three pure industrial ETFs.

Given today's environment, a reassessment of industrials' place in a portfolio is due. Traditionally they have sported stable earnings and dividends and anchored stock holdings. High book values from extensive plant and equipment cushion investors against loss and limit competition. Investors have traditionally paid a premium for these Blue Chips. Unfortunately, these firms' lifeblood is debt used to buy and replace such assets. With debt more costly or even unavailable, investors perceive debt-dependant firms as vulnerable. Right or wrong, opinions of investors have changed so blindly using traditional rules of thumb may be inappropriate. Such is the difficulty in picking sectors today.

As mentioned early in this report, the Dow is not really an industrials index. How did this happen? The Dow is over 100 years old, and during its infancy industrials were the most valuable companies by far. Even if industrials remain the single most important sector, energy, consumer, information technology and other sectors have gained share in the index. It's an outmoded index in its methodology. Still, DIA is a useful trading tool for the less frenetic trader and cyclical investor. Bid ask spreads are low, options are plentiful, and volatility is lower than with other major indexes. It surprised us to learn that DIA could show substantial tracking error (deviation from the index). On December 11, 2008, for instance, the midway between closing ask and bid traded at a 1.85% discount to Net Asset Value. However, such days are not the norm. During that same month tracking error on all be a few days was within .05 of NAV.

Claymore/Morningstar Manufacturing Super Sector ETF (NYSEArca:MZG) much resembles the Dow and is heavy with energy and consumer discretionary firms. We fail to see much usefulness in this super sector fund. Investors could build a more precise super sector with less costly multiple industry sector ETFs.

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
  • Invesco PowerShares FTSE RAFI Industrials Sector Portfolio ETF (NasdaqGM: PRFN); 0.6% fees

By using fundamental financial ratios other than market capitalization to weight holdings, these funds are likely to beat ETFs of traditional indexes, before fees. Unfortunately the fee difference is substantial. We also caution against using recent returns to project future performance, because recent activity has been unusual by any historical measure and is unlikely to be repeated during most years.

In addition there are three global 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
  • WisdomTree International Industrial Sector ETF (NYSEArca:DDI); 0.58% 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

Co-founder of indexfunds.com, author of two books on investing, and founder of ETFzone.com, Will has been writing on indexing issues for 8 years. He holds an MBA from the University of Texas at Austin.