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Recent data releases have been quite positive for the market. With the exception of the recent consumer sentiment, we saw both retail and industrial production data come in positive while strong growth was also seen in housing starts, indicative of a recovery in the housing sector (Best Construction ETF to Ride the Housing Upswing?).

Upbeat housing data led to a rally in homebuilder ETFs in the past few trading sessions, continuing their remarkable run. It seems that the residential construction sector is on the verge of recovery with tremendous upside potential going forward, potentially acting as a catalyst to the broad economy at large as well.

New residential construction or housing starts reported a sharp increase of 12.1% in December indicating that housing starts are close to a five-year high. This indicates that the industry may have bottomed out and is all set to rebound fueled by low-mortgage rates, smaller housing inventory and a growing population.                                                        

With improved buyers’ confidence in the market triggered by low housing prices as well interest rates, demand for housing will keep rising on the back of pent-up demand. This will keep the housing sector in a recovery mode for the next few years.

In fact, homebuilder exchange traded funds have been one of the top performing sectors in 2012 attributable to improving housing and job data. And with Fed expected to keep interest rates low, the sector could continue to perform well in 2013 (4 Best ETF Strategies for 2013).

With housing start numbers remaining high, both iShares Dow Jones U.S. Home Construction Index Fund (ITB - ETF report) and the SPDR S&P Homebuilders ETF (XHB - ETF report) surged higher in the initial hours of trading. ITB closed at $22.7, higher 2.71% while XHB posted a gain of 1.85% to close at $28.15.

ITB has been the best performing ETF in 2012, delivering a return of 78.9%. However, the fund still has to go a long way to catch the highs of 2007. Right now it is trading 50% below that level. XHB has also ridden a bull rally in 2012, recording a gain of almost 58% on the year (Two Sector ETFs to Buy in 2013).

Investors looking to capitalize on 2012’s best performing sector should invest in ETFs that have heavy exposure to the residential real estate market. And for a direct exposure to U.S. homebuilding companies, ITB represents an excellent option to play.

ITB offers a pure play into the sector as evidenced by its allocation of 65.37% of its asset base of $2 billion to home construction companies. Among building materials, home improvement and furnishing the allocation is limited to 40%.

The fund also offers exposure to 29 companies in which established homebuilders like Lennar Corp, Pulte Group and DR Horton Inc take up the top line of the fund.

All of these companies could be poised to deliver strong gains going forward thereby providing a boost to the performance of the ETF. The fund charges an expense ratio of 46 basis points.

Although the SPDR ETF is somewhat larger and a more liquid option to play in the sector it is probably not the right choice for investors looking for a direct exposure to residential real estate companies.

XHB has just 31.8% of its asset base of $2.3 billion in homebuilding while the rest is spread across building products, home furnishing retail, home improvement retail and household appliances (Is XHB a Better Housing ETF Play?).

However, related sectors have reaped the benefits from the resurgence in housing as exemplified by XHB’s performance in 2012.

XHB also offers a wider exposure to companies than ITB. XHB has its asset base invested in 37 companies. Lastly, the fund has an edge in expenses, charging 35 basis points annually.

The Bottom Line

Housing start numbers are expected to continue their uptrend. However, builders remain a tad cautious given some fundamental challenges very much at work, which include a still fragile economy, obstacles related to project funding and limited number of buyers qualifying for mortgage funding.

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