ETF Of The Week: Rare Earth Trade War Winners

On Wednesday, the U.S.-China trade war took a worrisome turn, when Chinese state media suggested the country could levy new tariffs on U.S. rare earth metal exports, in retaliation for the Trump administration's blacklist of Chinese telecom Huawei.

That would put U.S. tech companies, defense contractors, auto companies and health care firms in a bind. Rare earth metals that have become ubiquitous throughout their supply chains are largely sourced from China. Should rare earth metals prices skyrocket, U.S. firms would either have to cut back on their own production, or cascade higher prices down to the end consumer.

However, one U.S-based ETF would likely gain: the $199 million VanEck Vectors Rare Earth/Strategic Metals ETF (REMX). In fact, REMX has already seen boosted volume and flows over the past two weeks as a result of the trade dispute, with more activity sure to follow.

What Are Rare Earth Metals?

Rare earth metals (also known as rare earth elements) comprise a list of 17 elements, including the 15 lanthanides as well as scandium and yttrium. (However, they don't include other headline-making strategic metals like lithium or cobalt.)

Bright, soft and fairly temperamental—at least in chemical terms—the rare earth metals aren't actually all that rare in the earth's crust. But it's difficult to find them in large concentrations, and mining rare earth metals can be tough and expensive.

Used in trace amounts across tons of modern-day devices, rare earth metals can be found in everything from cancer drugs to aircraft engines, and from fluorescent light bulbs to electric car batteries. They're also used in consumer electronics, like tablets and smartphones, to make them smaller and more energy efficient.

For example, Apple (AAPL) is a massive consumer of rare earth metals, using them in its cameras and speakers (read: "iPhones & Teslas: 2 Rare Earth ETF Bets.”)

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

Where They Come From

Although China possesses 37% of world rare earth metal reserves, it accounts for roughly 70% of global production. That was intentional: In the late '90s, China ramped up its production capacity of rare earth metals, while the U.S. and other countries wound down their production.

As such, only one rare earth mine remains in the U.S. (Mountain Pass, in California), and today, the U.S. relies on Chinese imports for about 80% of its annual supply. Furthermore, even Mountain Pass is dependent on China for refining capacity. There are no rare earth metal refineries located outside China.

This means that, should the proposed Chinese tariffs on rare earth metals go into effect, the U.S. can't shift production stateside to compensate, because it simply doesn't have the production facilities. It would take years to ramp up that capacity again. Nor can other countries meaningfully fill the gaps. The U.S. needs Chinese rare earth metals. And the Chinese know it.

Massive Volume, Flows Into REMX

Year-to-date, REMX has performed decently, rising 9.44% on the back of U.S.-Chinese trade war tensions that began to intensify in March. Over the longer term, however, the fund hasn't done so great; since its price last peaked in January 2018, REMX has fallen 54%:

Starting last week, there was a massive uptick in REMX's trading volume. In the 10 years since it had first launched, REMX hadn't traded more than 700,000 shares in a single day. Then on Monday, May 20, traders exchanged more than 3 million shares; the next day, roughly 5 million shares traded. The volume spike coincided with a trip that Chinese President Xi Jinping took to the country's largest rare earth metals production facility.

Hot Topic

Trading in REMX died down for the rest of the week, only to flare up once again on Wednesday, May 29, as state-run Chinese television channels threatened that the country was willing to use rare earth metals as leverage in its trade war with the U.S.

This volume spike also coincided with significant inflows into REMX: On May 22, the fund saw a net gain of $41 million in investor assets, followed by $22 million on May 23.

In the past month, the fund has taken in $66 million. To put that in perspective, REMX's total new net inflows for the 12 months prior to May 1 were just $13 million.

Not Just Rare Earths In REMX

Investors contemplating REMX as a way to play the tensions over rare earth metals should keep a few things in mind.

First and foremost is that REMX doesn't actually hold any physical metal: It's an equity fund that tracks rare earth metals producers, refiners and recyclers.

Furthermore, although rare earth metals are at the core of the current trade dispute, REMX actually holds producers of rare earth metals and strategic metals, such as lithium, cobalt, tungsten and so on.

This puts REMX somewhat in competition with other ETFs that own lithium, cobalt and/or titanium miners, like the Global X Lithium & Battery Tech ETF (LIT) or the Amplify Advanced Battery Metals And Materials ETF (BATT).

However, REMX is still cheaper than both those funds, with an expense ratio of 0.59% compared to 0.75% for LIT and 0.72% for BATT. REMX has also outperformed both its competitors year-to-date; LIT has dropped 8%, and BATT has dropped 7%.

Charts source: StockCharts.com; data as of May 30, 2019

China Eats Its Own Lunch

About 26% of REMX's portfolio is in Chinese companies, followed by Australia (25%) and the U.S. (11%). Since the Chinese exposure is in A-shares, there could arise a disconnect between how offshore and onshore companies would perform, should the proposed tariffs go into effect.

Finally, perhaps the biggest thing to remember is that China is increasingly becoming a consumer of its own rare earth metals, rather than just producing them for export. Therefore, the country may not be as dependent on U.S. consumption as it may seem.

Many analysts believe that any drop-off in U.S. consumption would be offset by a massive spike in prices that a rare earth metals tariff would inevitably cause. This would bolster support for the Chinese producers in REMX's portfolio—which would mean good things for the fund's future returns.

Contact Lara Crigger at [email protected].