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The ETF Advisor: Basic Materials ETFs

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Every day, investors are bombarded with economic data offering clues to future market movements. As the U.S. and global economies begin to emerge from recession, a stark dividing line has emerged among investors: those who believe the recovery is real and will gain momentum, and those who fear it is a momentary respite from further decline.

For optimists, the basic materials sector–forest products, chemicals, steel, and mining–offers intriguing possibilities. Basic materials are highly cyclical, so with growth returning, basic material ETFs might offer a convenient way to profit from a strengthening global economy.

“The earnings outlook for the materials sector is really powerful,” says Alec Young, international equity strategist with Standard & Poor’s Equity Research, noting that S&P analysts are looking for a 94% gain in profits from basic materials companies in the S&P 500 during 2010. S&P recommends overweighting the materials sector, which was up 38.4% year-to-date as of October 23, 2009, compared with a 19.5% gain for the S&P 500. “As long as we’re looking at a slow recovery, the sector should be able to see above-average earnings growth next year, even if it’s a relatively weak global recovery,” Young says.

Of the nearly dozen ETFs focused on the materials sector, many are heavily weighted to the chemicals sector, with smaller positions in mining and metals producers, forest product companies, or packaging firms. ETFs that describe themselves as “natural resource” funds are similar, but usually also have large allocations to energy companies.

In terms of assets held, State Street’s Materials Select SPDR (XLB), with $1.7 billion, dominates the field. It holds 32 different stocks, led by agricultural technology developer Monsanto, Freeport-McMoran, and du Pont. The fund’s two main rivals–Vanguard Basic Materials (VAW) with $518 million in assets, and iShares Dow Jones US Basic Materials Sector Index (IYM) with $680 million–are virtually identical.

Two smaller funds offer a somewhat different approach: First Trust Materials AlphaDEX (FXZ) has $16 million in assets invested in 54 stocks. Its top holding is flooring manufacturer Amerstrong World Industries, followed by industrial lubricant maker Lubrizol, and buildings material maker Owens Corning. The Rydex S&P Equal Weight Materials (RTM), with $41 million in assets, has many of the same holdings as the larger funds. The big difference is disclosed in the ETF’s name; the holdings are equally weighted.

Three international materials ETFs are currently listed in the U.S., and they, too, have nearly identical holdings. The largest is iShares Global Materials (MXI), followed by Wisdom Tree International Basic Materials (DBN), and State Street’s SPDR S&P International Materials Sector ETF (IRV).

S&P’s methodology for ranking ETFs incorporate not only past performance, but also underlying holdings, risk, and, particularly important in this category, expenses.

S&P Senior Financial Writer Vaughan Scully can be reached at [email protected]. Send him your ideas for ETF story topics.