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ETF Specialist

Strong Material for a Volatile Sector

This low-cost ETF offers one of the best ways to get exposure to the U.S. materials sector.

The materials sector represents a very thin sliver of the U.S. stock market--just over 3% of the S&P 500. In contrast, this sector soaks up a meatier 9% of the FTSE All World ex-US Index. That’s partially because many of the leaders in the metals and mining industry are based outside the United States. Investors looking for greater exposure to this sector without delving into foreign stocks might consider  Vanguard Materials ETF (VAW). But this is appropriate only for investors with a high risk-tolerance.

This is one of the cheapest and most comprehensive U.S. materials-sector funds available to individual investors. It offers exposure to nearly every publicly traded materials company based in the U.S. for a razor-thin 0.14% expense ratio. This includes companies operating in the chemicals, metals and mining, paper and forest products, containers and packaging, and construction materials industries. Most of these companies sell into cyclical commodity markets. They also have to contend with volatile raw-material and energy prices and high fixed costs. The fund's broad reach into small- and mid-cap territory makes it more susceptible to these operational risks. During the past five years, this fund was about 50% more volatile than the S&P 500. While its holdings’ sensitivity to the business cycle can introduce significant risk, it may also allow investors to profit handsomely from economic growth.

The fund invests in an eclectic mix of companies, including  Monsanto ,  Freeport-McMoRan (FCX), industrial gas companies  Praxair (PX) and  Air Products & Chemicals (APD), as well as global metals producers  Alcoa and  Nucor (NUE). However, like its U.S. materials-sector peers, this is primarily a chemicals fund. Because of its industry concentration, this fund would be most suitable as a tactical holding in a diversified portfolio.

The products that chemicals companies produce are found nearly everywhere. They are incorporated into plastics, paints, homes, electronics, cars, petroleum, industrial gas, coatings, fabrics, and agricultural products, among others. Consequently, demand for these companies' products is cyclical. Many of the fund's small- and mid-cap holdings lack the competitive advantages necessary to insulate their profits from this cyclical demand. Durable competitive advantages in the chemicals industry are generally built around specialty products and access to low-cost inputs. Some of the fund's top holdings, including Monsanto,  DuPont , and  PPG Industries (PPG), have built competitive advantages by moving up the value chain into more-specialized, higher-margin products. However, wide moats are scarce in this industry.

Fundamental View
The shale gas boom has reduced feedstock costs for North American chemical producers relative to chemical manufacturers in Europe, which are more dependent on higher-cost naphtha (a heavy crude-based feedstock). However, industry margins could contract as chemical producers continue to add new capacity. Cyclical demand also poses a challenge. In order to reduce the volatility of their earnings, some of the fund's chemicals holdings are shifting toward less-cyclical, higher-margin specialty products, though most are still dependent on cyclical basic chemicals. DuPont and  Dow Chemical (DOW) are taking steps to divest a portion of their commodity chemicals businesses. These two companies have also developed significant agricultural chemicals and genetically modified seed businesses to reduce their dependence on commodity chemicals.

The fund also has significant exposure to the agricultural industry through pure-play agriculture chemical and seed maker Monsanto and fertilizer makers  Mosaic (MOS) and  CF Industries (CF). Crop prices can have a significant impact on demand for yield-enhancing seeds, chemicals, and fertilizer in the short term because farmers' incomes are closely tied to them. But ultimately, these firms' ability to stay ahead of their competitors in the race to meet the growing demand for food will drive their performance. Growth in global population and meat consumption in emerging markets will require agricultural output to increase substantially over the next few decades, according to projections from the Food and Agricultural Organization. Because the amount of arable land is relatively fixed, these long-term trends likely will increase demand for yield-enhancing products.

Chinese infrastructure development has a significant impact on the demand for industrial metals. However, Chinese demand for industrial metals may soften over the long run, as the country starts to shift away from its investment-driven growth model. The Chinese real estate market is starting to show signs of weakness, with an 11% year-over-year decline in housing starts for the period January through August and a 9% decline in commercial building sales. According to Morningstar equity analysts, prices have fallen in most of China’s major cities and may remain soft in the face of a supply glut and weakening demand. That could be bad for iron and copper prices and the companies that mine them because the Chinese real estate market accounts for a large portion of global demand for those metals.

Gold miners, such as Freeport-McMoRan and  Newmont Mining Corp (NEM), also face a challenging operating environment. Gold prices have receded from record highs, as costs remain elevated. While the outlook for the industry is not promising, metals and mining stocks represent only about 17% of the portfolio.

Based on Morningstar equity analysts’ fair value assessments of the funds’ underlying holdings, it is trading at a price/fair value multiple of 1.01, as of this writing. Because its holdings face significant risks, it might be worthwhile to wait until the fund trades at a discount to its fair value before buying. At of the end of August, it was trading at a slightly higher price/forward earnings ratio (19.2) than the S&P 500 (17.5).

Portfolio Construction
The fund employs full replication to track the MSCI US Investable Market Index (IMI)/Materials 25/50 Index. This benchmark includes all companies that fall in the GICS materials sector from the MSCI USA Investable Market Index, which represents close to 99% of the total U.S. stock market. MSCI follows a modified cap-weighting approach that limits individual constituents to 22.5% of the portfolio, though none of the fund's holdings come close to that limit. Additionally, the combined weighting of all companies above 4.5% may not exceed 45% of the index. These limits allow the fund to conform to IRS requirements for registered investment companies. MSCI reviews the index quarterly.

Small- and mid-cap companies soak up nearly 43% of the fund's assets. This gives the portfolio an average market cap of only about $17 billion. Chemicals companies represent approximately 67% of the portfolio, followed by metals and mining (17%), containers and packaging (9%), paper and forest products (4%), and construction materials stocks (3%).

 Fidelity MSCI Materials ETF (FMAT) tracks the uncapped version of VAW’s index, which is virtually identical, for a slightly lower expense ratio (0.12%). However, it is more thinly traded than VAW, which could make it more expensive to trade. Therefore, VAW is still the better deal, in our view.  Materials Select Sector SPDR ETF (XLB) (0.16% expense ratio) invests in every materials company in the S&P 500, which gives it less exposure to the small players in this sector than VAW. The large-cap companies that XLB owns tend to enjoy stronger competitive advantages and exhibit a little less volatility than their small-cap counterparts. However, this narrower focus gives XLB a more concentrated portfolio.  IShares US Basic Materials (IYM) offers similar exposure as VAW, though its portfolio is less comprehensive. Its 0.45% expense ratio also makes it a less attractive alternative. Like VAW, XLB and IYM both tilt toward the chemicals industry.

Investors looking for more-balanced exposure to the materials sector might consider  iShares Global Materials (MXI) (0.48% expense ratio). In contrast to VAW, MXI invests in both U.S. and non-U.S. materials stocks. This global reach allows it to hold many of the industry leaders in the metals and mining industry that are not available to VAW. Consequently, it offers greater exposure to the metals and mining industry and less exposure to the chemicals industry than VAW.

Investors looking for broad commodity-linked equity exposure might also consider a natural-resources fund, such as  SPDR S&P Global Natural Resources ETF (GNR) (0.40% expense ratio). GNR targets the world's 90 largest stocks in the energy, agriculture, and metals and mining industries.

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Alex Bryan does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.