Industrials ETFs Seek Fortune Abroad
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A rebound in US manufacturing exports is buoying industrial sector ETFs. But this surge is only one of relative strength against a background of overall weakness of demand for manufactured goods.
Manufacturing expectations rebounded smartly in September 2009, according to Manufacturers Alliance/MAPI, but this was from historic lows in June 2009. Manufacturers still expect production to contract slightly in Q4 2009 and Q1 2010. Expansion is not anticipated until well into 2010. Likewise, expectations for capital investment expectations and R&D are tepid for 2010. The worst may be over, but the picture is not exactly rosy.
Experienced ETF investors know to look beyond popular DIAMONDS (AMEX: DIA) for true industrials exposure. DIA's underlying index, the antiquated Dow Jones Industrials, contains only 20% of manufacturing firms producing finished goods. Happily there are low-cost ETFs which follow industrial manufacturing faithfully. 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.
The three bona fide industrials ETFs correlate convincingly:
Industrials used to mean steel mills, but today they are more likely to be sophisticated manufacturers such as in aerospace and defense. (Basic materials is a better sector to find heavy industrial production). General Electric is typically the #1 holding in most industrials ETFs. VIS currently holds over 12.5% in GE, more than might seem sensible in a diversified index. But in fact GE is really a collection of unrelated companies and thus has internal diversification. The funds all include names such as Caterpillar, 3M, Boeing and United Technologies. Transportation companies such as Union Pacific and United Parcel Service are slotted with industrials because transportation no longer has sufficient value to maintain their own sector.
International sales are the brightest spot for industrials, which traditionally sell more abroad than the average company. A survey by PriceWaterhouseCoopers in Q3 2009 reports that while more manufacturers expect a decline (39%) in international sales than a climb (22%), nonetheless they expect 34% of sales to come from abroad during the next 12 months. This is 4% higher than the previous quarter's prediction. Exports are an area of relative, not absolute strength.
International sales now enjoy the tailwind of a weak dollar when sales in strong foreign currencies are repatriated. When the dollar strengthens, which seems unlikely in the near-term, a forex headwind will have the opposite effect.
Industrial companies are appropriately keen on expanding into new markets, according to GlobalSpec. New market development ranks as the number one concern in 2009, jumping ahead of quality which was the top focus in 2008. Pricing pressure in 2009 replaced the dominant concern of raw materials cost in 2008.
In this era of tight credit (except for banks which are hoarding to build capital reserves for unannounced real estate losses), industrials remain vulnerable to the credit crunch. Firms report gathering cash reserves instead of paying out dividends or buying back stock.
Industrials ETFs tend to spit out 2-3% dividend yields, which is enough to make income-oriented investors take notice. Investment grade bond yields are quite low.
Given today's environment, a reassessment of industrials' place in a portfolio is due. Traditionally they have sported stable earnings and dividends. High book values from extensive plant and equipment cushion investors against loss and limit competition. Unfortunately, enormous amounts of debt are typically used to purchase capital assets and this must be refinanced from time to time. With debt costly or even unavailable, investors are justifiably wary of debt-laden firms. Investors have traditionally paid a premium for these Blue Chips, but a sea change has occurred. Such is the difficulty in picking sectors today.
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 0.40%-0.50% or so 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 strongly to smaller firms.
Claymore/Morningstar Manufacturing Super Sector ETF (NYSEArca:MZG) goes beyond manufacturing to include energy and consumer discretionary 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
- WisdomTree International Industrial Sector ETF (NYSEArca:DDI); 0.58% fees
- Emerging Global Shares Dow Jones Emerging Markets Industrials Titans ETF (NYSEArca:EID); 0.85% 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