ETF Of The Week: Materials Fund Spiking

An often overlooked beneficiary of lower interest rates is the materials sector; even the promise of lower rates is enough to send these stocks spiraling higher, as investors in the Materials Select Sector SPDR Fund (XLB) have discovered recently.

The ETF, which tracks materials companies such as chemicals manufacturers and packaging giants, is up 4.5% over the past month, making it the best-performing ETF of the SPDR Select Sector ETF suite of the past 30 days.

That's all because the Fed has hinted it might cut interest rates, thus improving the attractiveness of American-made goods to foreign buyers and lowering the cost of capital expenditures.

Investor money has followed XLB's outperformance: About $713 million in net assets has flowed into the fund since June 1, growing its assets under management by 21%. Year to date, however, XLB has still lost a net $85 million in assets.

Source: ETF.com; data as of June 13, 2019

Why Materials Rise When Rates Fall

It might seem counterintuitive that a sector as export-dependent as basic materials would outperform at the same time relations between the U.S. and its trade partners are souring.

Strength in the materials sector has less to do with White House saber-rattling, however, and more to do with interest rates.

The Fed has indicated that, this fall, it may lower its benchmark interest rate. Should it do so, then lower rates would put pressure on the value of the U.S. dollar, in turn making exports denominated in the greenback cheaper for foreign buyers. Presumably, that would boost demand, even if the trade war continues.

Materials companies also often require significant capital expenditure outlays; lower interest rates would make those expenses cheaper.

XLB vs. VAW: Under The Hood

At $4.1 billion in assets under management, XLB is the largest materials ETF on the market, tracking all the basic materials companies found in the S&P 500 Index.

Its strongest competition comes from the Vanguard Materials ETF (VAW), which has almost $2.0 billion in assets. (The other 12 materials ETFs each have less than $400 million invested.)

Both XLB and VAW are dominated by chemicals producers, first and foremost: Chemicals stocks comprise 72% of XLB and 60% of VAW.

But there are some portfolio differences between the two funds.

More Narrow Take

For starters, XLB is a much narrower take on the materials sector, holding only 29 names compared with VAW's 120. As such, the holdings in each fund are roughly the same, but with different weights: For example, the top stock in both, Linde Plc, has a 16% weight in XLB and an 11% weight in VAW. Also, VAW holds far more smaller cap names.

(Use our stock finder tool to find an ETF’s allocation to a certain stock.)

Concentration can be a benefit, though, as XLB's narrower focus has helped it outperform VAW. Year to date, XLB is up 14.5%, while VAW is up 13.7%:

Source: StockCharts.com; data as of June 13, 2019

Trading Cost Matters

Ultimately, the choice between XLB and VAW may be one of cost. At 0.10%, VAW carries the lower expense ratio; XLB costs 0.13% annually. However, XLB has a much lower spread, at 0.02% versus VAW's 0.05%.

For investors engaging in a sector rotation strategy, trading executions matter—meaning XLB may be the better choice, as its liquidity is unmatched, even by the 800 lb. gorilla that is Vanguard.

Contact Lara Crigger at [email protected]