Materials ETFs: Firing Up the Stalled Economy

The collapse in global demand in the final quarter of 2008 took a big bite out of basic materials ETFs. Chemicals, industrial metals, paper and timber products tend to be so far upstream in the production process that faltering demand anywhere along the production chain threatens pricing power. The opposite is also true: in a growing economy with demand on the upswing, raw material companies exert more control. The sector is highly cyclical, and it is currently in its downswing.

Although significant demand recovery may be some time away, depressed prices make it worth taking a look at materials ETFs now. The three most important ETFs in the materials sector are the Materials Select Sector SPDR (NYSEArca:XLB), Vanguard Materials ETF (NYSEArca:VAW), and the iShares Dow Jones Basic Materials (NYSEArca:IYM). XLB and VAW are the obvious low-cost choices with expense ratios of 0.23% and 0.2% respectively compared to IYM's 0.48%. VAW is more diversified but tends to have higher turnover expenses.

The chart below compares the performance of these three ETFs: with the benchmark Standard and Poor's Depositary Receipts (AMEX:SPY):

The chart shows the three basic materials ETFs shed between 50% and 60% before recovering slightly after Thanksgiving. The rapidity of the sell-off and underperformance in relation to the benchmark is unusual for these ETFs. IYM's performance lags the other two in part because it doesn't have a significant position in Monsanto, an outperforming agricultural products and genomics company, by far the largest holding in both XLB and VAW.

Investors have historically prized raw materials companies for their abundant fixed assets: the property, plants and equipment needed for materials production. These firms traditionally have high book values and pay regular and reliable dividends which help to offset cyclical swings in the stock price. But global downsizing seems to have caught many in the basic materials sector off guard. After years of expansionary thinking fueled by the emergence of China and EM economies, many of these companies have acquired significant debt and excess production capacity. Many are cutting their dividends, adding to volatility.

Demand recovery will probably not pick up until business manufacturing activity starts to grow again. One gauge of manufacturing activity is the ISM Manufacturing Index. The ISM Index is based on a survey of purchasing managers in manufacturing. The index reflects inventories, production, deliveries as well as new orders.

An ISM above 50 indicates growth in the sector. Below 50 indicates contraction. As the chart shows, the ISM index has been falling slightly for years-- meaning that growth in the sector has been slowing. Then manufacturing hit a wall in September of 2008. ISM fell from 49.3 in August to 43.4 in September. A reading below 40-41 is associated with broad economic troubles. The data suggests that manufacturing activity is still contracting regardless of small upticks.

The sudden collapse in global demand, fall-off in manufacturing activity, and full materials pipelines for manufacturers suggests that it will be awhile before growth in the sector recovers. But materials ETFs may nonetheless be attractive for investors at these levels on a valuation basis. Companies in this sector control raw materials which are essential to production. These companies boast significant fixed assets that ensure a high cost to setting up an operation in the sector. This cost provides barriers to entry for competition and allows these companies a measure of monopoly pricing. Because raw materials tend to hold value in inflationary times, the inevitable return to inflation will likely help this sector.

Following is a list of Basic Materials ETFs:

Standard Index:

Materials Select Sector SPDR Fund (NYSEArca:XLB)

Vanguard Materials ETF (NYSEArca:VAW)

iShares Dow Jones U.S. Basic Materials Sector Index Fund (NYSEArca:IYM)

iShares S&P Global Materials Sector Index Fund (NYSEArca:MXI)

Fundamental:

Powershares Dynamic Basic Materials Sector Portfolio ETF (NYSEArca:PYZ)

Powershares FTSE RAFI Basic Materials Sector Portfolio ETF (NasdaqGM:RTM)

First Trust Materials AlphaDEX Fund (NYSEArca:FXZ)

Short/Leverage:

Ultra Basic Materials ETF (NYSEArca:UYM)

UltraShort Basic Materials ETF (NYSEArca:SMN)

International:

SPDR S&P International Materials Sector ETF (NYSEArca:IRV)

WisdomTree International Basic Materials Sector Fund (NYSEArca:DBN)