Are Homebuilders ETFs Right for Your Investment Strategy?

What to consider before investing in these funds

Builders Work on Large Home Being Built in Woodsy Area

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If you are looking for a way to invest in the housing construction industry, you may want to consider homebuilders' exchange-traded funds (ETFs). These funds primarily invest in shares of companies that produce or sell building products or home furnishings and appliances. But before you invest, it’s wise to understand the trends and dynamics of the homebuilding industry, and what tends to affect the performance of these stocks.

Home Construction Industry Outlook

Generally speaking, the returns on housing construction stocks are usually tied to the health of the housing industry. For example, when interest rates on home loans and mortgages are low or falling, the demand for new or renovated homes often stays steady or even rises.

Homebuyers, real estate investors, and existing homeowners increasingly buy, invest, or refinance when rates are down to take advantage of the cheaper borrowing costs associated with lower rates. 

Another example is the low-interest rates on mortgages in the United States through the first half of 2021. This, combined with low unemployment rates, has helped support a healthy housing market in which consumers and investors are buying homes, renovating existing ones, and purchasing home furnishings and appliances to put in them. 

This trend, in turn, has spurred strong performance by homebuilder stocks. For example, as of June 30, 2021, homebuilder stocks, as measured by the SPDR S&P Homebuilders ETF (XHB), had a gain in market value of 68.58% for the year. The broader U.S. stock market, as tracked by the SPDR S&P 500 ETF (SPY), had a gain in market value of 40.79%. 

Conversely, during the housing bust and recession that started in 2007 and 2008, homebuilder ETFs were hit particularly hard. In those years, the SPDR S&P Homebuilders ETF lost 47.70% and 36.28% of its value, respectively.

In recognition of the potential for wide price swings for stocks in the homebuilding sector, investors would be wise to take note of the risk-reward ratio. For example, when an investment has the potential for high, short-term gains, it usually also has a chance for dramatic short-term losses. 

Benefits of Homebuilder ETFs

The primary benefits of investing in homebuilder ETFs include:

  • Diversification: Like other sector funds, homebuilder ETFs also can be used for portfolio diversification. Rather than buying one or two individual stocks of homebuilding or related companies, investors can purchase a basket of dozens of homebuilder stocks in one ETF. 
  • Simplicity: Instead of purchasing land, building housing developments, or buying individual stocks in the home construction industry, you can more simply invest in the industry by purchasing shares of a homebuilders ETF.
  • Growth trends: If you believe that economic trends favor homebuilders, homebuilder ETFs can help you profit from that phenomenon. However, given the dramatic ups and downs of the real estate market, you should have a high tolerance for risk if you buy into this sector’s ETFs.

Who Homebuilders ETFs Are Best for

Homebuilders' ETFs can be smart investments, but they are not well-suited for everyone. Investors with these qualities may be right for homebuilders' ETFs.

  • High-Risk Tolerance: Investments that narrowly focus on one particular industry or market niche tend to carry higher market risk than an investment in a broad market index, such as the S&P 500 index. Investors with a high-risk tolerance may be able to handle the market swings best.
  • Long-Term Time Horizon: Because homebuilders' ETFs may have high relative market risk, holding them longer-term (at least five years but ideally 10 years or more) is prudent. Longer holding periods allow for recovery from short-term declines in value.
  • Industry Knowledge: You don’t need to be an expert in home construction to buy homebuilders' ETFs. However, investors may be wise to avoid investing in something they don’t understand. Do your research before you invest.

The Bottom Line

Homebuilders ETFs can be a savvy investment choice for investors seeking exposure to stocks of companies in or related to the home construction industry. Sector ETFs like these can be used as a diversification tool when included in small percentages in a broad, diversified portfolio. However, investors should keep in mind that investing in narrowly focused sector funds like homebuilders' ETFs can increase market risk. High relative market risk is associated with higher relative volatility (price movement up and down). As a result, if an investor chooses to buy homebuilders ETFs, they may want to allocate only a small percentage, say 5% to 10% of their overall portfolio, to riskier investments like these. Therefore, homebuilders ETFs may be most appropriate for investors with a high tolerance for risk.

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