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Time for This Top Ranked Industrial ETF?

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With the U.S. economy gathering strength, the capital goods and the industrial manufacturing sector is coming into focus. This sector is basically a cluster of all the cyclical and economically sensitive companies, and it functions in accordance with the overall health of the broader economy.

With an optimistic sentiment prevailing in the industry, investors are increasingly shifting the spotlight from the defensive sectors like utilities and consumer staples to cyclical sectors like industrials.

The industrial sector has recently attracted investor attention, thanks to improved domestic demand for industrial equipment and will continue to post decent growth strengthened by the airline, railroads, and shipping companies as well.

Recent Trends

Although manufacturing activity declined in May 2013 as per the ISM manufacturing index, for the first time in six months, hurt by lower new orders and less demand for exports, we believe the sector still has plenty to offer. With recovering employment levels and growing consumer confidence, this sector should deliver modest growth for the rest of the year (Read: Can U.S. Manufacturing Industries Keep Expanding?).

Prior to May, the industrial production was rising at a solid clip, enhanced by decent levels of manufacturing and mining. Improvement was also noticed in the capacity utilization rate. Moreover, of the 18 U.S. manufacturing industries listed, 10 actually reported growth in May.

Although the Fed chairman, Ben Bernanke, recently suggested that the Fed may scale down its easy money policy of $85 billion a month in bond purchases later this year and to seal the program by mid 2014, we believe, time to panic over such moves has not come yet as the U.S. industry gathered considerable strength to ride on its core fundamentals (Read: Winning ETF Strategies For the Second Half).

Given this, a look to a broad pick in the competitive space may be a good idea, as it will spread risk around while still allowing for the ability to tap into the positive longer-term trend in the space. While there are a number of industrial ETFs on the market, one way to target the best the sector has to offer is by looking only at top ranked funds using the Zacks ETF Rank.

About the Zacks ETF Rank

The Zacks ETF Rank provides a recommendation for the ETF in the context of our outlook for the underlying industry, sector, style box or asset class (Read: Zacks ETF Rank Guide). Our proprietary methodology also takes into account the risk preferences of investors. ETFs are ranked on a scale of 1 (Strong Buy) to 5 (Strong Sell) while they also receive one of the three risk ratings, namely Low, Medium, or High.

The aim of our models is to select the best ETFs within each risk category. We assign each ETF one of the five ranks within each risk bucket. Thus, the Zacks Rank reflects the expected return of an ETF relative to other products with a similar level of risk.  

For investors seeking to apply this methodology to their portfolio in the Industrial sector, we have taken a closer look at the top ranked XLI. This ETF has a Zacks ETF Rank of 1 or Strong Buy and more details about this product are highlighted below:

Industrial Select Sector SPDR (XLI - Free Report)

Launched in Dec 1998, Industrial Select Sector SPDR (XLI - Free Report) is a passively managed exchange traded fund (ETF) designed to track the performance of the S&P Industrial Select Sector Index, which is dominated by the stocks of different industries within this sector.

This fund is by far the most popular industrial ETF in the space with more than $5 billion in AUM and an average daily volume of over 10 million shares.  Holding 63 stocks in its basket, the fund is moderately diversified across large cap securities.

The product puts nearly 50% of its total assets in the top 10 holdings, suggesting that company-specific risk and return is higher. Among individual holdings, General Electric Co (GE - Free Report) takes the top spot with a share of 12% while United Technologies Corp. ((UTX - Free Report) ) is in second with 5.4% share, and Union Pacific Corp. ((UNP - Free Report) ) follows shortly with 5.2% share in the fund.

From a sector viewpoint, the ETF has maximum exposure in the better-positioned Aerospace and Defense sector with around 25.1% allocation. This is followed by Industrial Conglomerates and Machinery sectors with around 19.4% and 19.3% allocation, respectively (see all the Top Ranked ETFs).

As far as expenses are concerned, XLI is by far one of the cheapest options on the industrial equities list with a fee of just 18 basis points a year. This is far below the average expense ratio of 0.5% in the space, suggesting that it could be an interesting choice for those seeking to keep total fees low.

The fund structure is a fine mix of value and growth style fund and focuses on large cap securities. This large cap focus makes this fund a low-risk opportunity, especially compared to others in the space.

As such, we have a ‘Low’ risk outlook for XLI in the near term. However, being termed as low risk definitely does not mean low returns for the ETF.

Bottom Line

Weakness in some of the regional Fed reports, and concerns over global central bank action, have dragged down this ETF lately from its lofty heights. However, the outlook in many of the fund’s key industries is still quite bright, suggesting it is still a decent play.

This is particularly true when one considers the current industries that are in favor in the market. Right now, low growth, low beta, sectors are out of vogue, allowing investments in sectors like industrials to lead the way (see more in the Zacks ETF Center).

Given this trend, a top Ranked ETF like XLI might be a solid choice in today’s environment. The sector could easily the way out of this current slump, and XLI’s makeup is well-positioned to take advantage of this once investors calm down about Bernanke and the Fed’s policies.  

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