Underbought Rally In Materials ETFs

The U.S. basic materials sector is delivering one of the strongest performances among S&P 500 sectors this year, but one that has gone largely unnoticed by investors if ETF asset flows are any indication.

Materials is up some 16.6% year-to-date, the third-best-performing sector this year—and one that’s outpacing gains in the broader S&P 500 by more than 2.5 percentage points. Yet U.S. materials ETFs in the market today (excluding funds that specifically target small- and midcap companies) have seen combined net inflows of less than $250 million year-to-date.

The three largest U.S. materials ETFs—the $4 billion Materials Select Sector SPDR Fund (XLB), the $2 billion Vanguard Materials Index Fund (VAW) and the $900 million iShares U.S. Basic Materials ETF (IYM)—are all up more than 18% in 2017, led by the strong performance of their underlying holdings. 

Key Differences

These three funds’ performance may not seem all that different, but the portfolios are. Consider that among the big three, XLB is the uncontested leader in the segment, with more than $4.1 billion in total assets and massive liquidity. But the fund is also the most concentrated bet on materials.

XLB invests in only about 25 companies, and thanks to its market-cap-weighting scheme, the portfolio is heavily tilted toward a few names—its top five holdings represent nearly 50% of the total portfolio. 

These top holdings include names like DowDuPont, Monsanto, Praxair, Ecolab, Air Products & Chemicals and Sherwin-Williams, companies that have been delivering solid gains this year. DowDuPont, which represents roughly 24% of the portfolio, is up more than 27.6% so far this year; Monsanto stock prices are up 16%; Praxair is up 23%.

Relative to XLB, both VAW and IYM have broader portfolios that extend into companies of smaller capitalization. While XLB’s weighted average market cap is $58.1 billion in a portfolio of 25 securities, VAW’s is $37 billion in a mix of 119 companies, and IYM’s is $45 billion in a portfolio of 50 names. 

These funds also come with very different price tags. VAW, the cheapest, with a 0.10% expense ratio, costs less than a quarter of what IYM charges—0.44%. That’s $10 per $10,000 invested versus $44 per $10,000. XLB’s price tag is 0.14%.

A Newcomer

There’s also the youngest entrant to the vanilla materials space, one that didn’t innovate in terms of strategy, but did in cost.

The Fidelity MSCI Materials Index ETF (FMAT), launched four years ago, tracks an MSCI market-cap-weighted index much like VAW does, providing investors with nearly identical vanilla exposure. But the fund does so for 0.08% in expense ratio—or $8 per $10,000 invested.

If you look beyond the three largest offerings in this segment from the three largest ETF issuers, fund choices get even more diverse.

Smart Beta ETF Choices

There are a few smart-beta flavors of materials ETFs, which include the quant-driven First Trust Materials AlphaDEX Fund (FXZ); the PowerShares DWA Basic Materials Momentum Portfolio (PYZ); the equal-weighted Guggenheim S&P 500 Equal Weight Materials ETF (RTM); and a pair of multifactor newcomers.

None of these funds has managed to outperform the vanilla materials ETFs so far this year—here’s how their year-to-date returns compare with XLB: 

Charts courtesy of StockCharts.com

But smart beta isn’t necessarily about outperformance as much as it’s about an alternative take on the market.

In the case of FXZ, for example, the methodology relies on various metrics of growth and value factors to pick and rank securities. The strategy is designed to deliver exposure to what First Trust sees as the best materials companies in the Russell 1000 based on those factors.

The mix also tilts away from the larger-cap names. The 52-stock portfolio has a weighted average market cap of only $14.75 billion, and has gathered some $341 million in total assets despite its pricier tag of 0.66% in expense ratio.

PYZ, meanwhile, centers its strategy on price momentum. The fund relies on a Dorsey-Wright relative strength index that picks and weights securities by price momentum, investing in companies that are seeing strongest price gains relative to the broader universe.

The fund, which switched its original methodology back in 2014, has yet to find much traction. PYZ has $100 million in total assets gathered since its 2006 inception. It costs 0.60%.

And then there’s RTM, which is essentially an equal-weighted version of XLB. In this portfolio, the smaller-cap names are assigned the same weighting as some of the largest materials companies.

This type of approach tends to outperform traditional market-cap strategies when gains are widespread across a sector, but so far this year, RTM has slightly underperformed as bigger companies lead the sector in gains.

With $173 million in total assets, RTM costs 0.40% in expense ratio—less than iShares’ vanilla IYM.

Multifactor Angles On Materials

Both the John Hancock Multifactor Materials (JHMA) and the iShares Edge MSCI Multifactor Materials ETF (MATF) launched last year, offering multifactor takes on the materials sector. JHMA tracks an index that selects stocks by market cap but weights them by multiple factors such as size, value, profitability and momentum. MATF both selects and weights securities based on the factors of value, quality, momentum and low size.

With $5 million in total assets, MATF is the smallest and cheapest of the two, with an expense ratio of 0.35%. JHMA has $21 million in assets, and costs 0.50%. MATF is also the best performer, delivering some 20% in gains year-to-date versus JHMA’s 17%.

Price Wins

In a popularity contest, the cheapest materials ETF, FMAT, would come second in 2017, raking in net inflows of $66 million—second only to VAW’s $149 million haul.

Investors may have largely ignored the rally in materials, but those who’ve jumped on the wagon overwhelmingly have shown preference for the cheapest two funds in the segment.

XLB, the largest materials ETF, has seen net creations of only $19.4 million this year, while IYM took in $40 million.

Quants FXZ and PYZ have actually bled assets this year despite gains, facing net redemptions of $28 million and $10 million, respectively, so far in 2017.

RTM—the only equal-weighted materials fund—has quietly raked in $8 million in fresh net assets year-to-date, while newcomer multifactor funds MATF and JHMA have each attracted a modest $1.5 million in net inflows.  

Contact Cinthia Murphy at [email protected]