FXZ And RTM: Material Evidence
Summary An opportunity for long term investors to be pre-positioned in the materials sector. One fund is equally weighted, conservatively invested; the other more diversified and alpha weighted. Either fund challenges the investor to take advantage of the business cycle. There’s an old Wall Street adage to ‘buy low, sell high’ and based on the basic principles of investment, this statement is axiomatic. However, it does beg the questions, ‘how low is low?’ and ‘how high is high?’ So to apply this axiom, the idea would be to find an investment that is low. Anyone who has paid attention to global financial news over the past few months is well aware that the supply of strategic materials, as well as production, has run far, far ahead of demand. But just what is the ‘materials sector’? According to Investopedia : … A category of stocks that accounts for companies involved with the discovery, development and processing of raw materials. The basic materials sector includes the mining and refining of metals, chemical producers and forestry products. .. So apparently, this is a starting point: supply is high, demand is low therefore prices decline, thus profits, thus stock prices of ‘basic materials’ producers. (click to enlarge) Unless one has the time, effort, patience and knowledge to analyze and filter through the hundreds, if not thousands of global basic materials manufactures, it best to select a basic materials ETF and then a ‘plain vanilla’ one at that. Lastly, the individual would be wise to select the best fund in the class. By filter U.S.Equities => Basic Materials=> All, then excluding ‘Leveraged’, ‘Inverse’ and ‘ETN’, the very handy Seeking Alpha’s ETF Hub tool identifies nine suitable results. There are two candidates with a “least bad” one year performance and the best three year performance. First is the Guggenheim’s S&P Equal Weight Materials ETF (NYSEARCA: RTM ) and second is the First Trust Materials AlphaDEX ETF (NYSEARCA: FXZ ) . According to Guggenheim , the investment’s objective is to: … replicate as closely as possible, before fees and expenses, the performance of the S&P 500 Equal Weight Index Materials[S15] … Clearly, the 28 component holdings of the Guggenheim Materials fund are then equally weighted and readjusted quarterly according to the index it tracks. The underlying S&P tracking index: …imposes equal weights on the index constituents included in the S&P 500 that are classified in the GICS® materials sector… (Note that ” GICS ® ” is an abbreviation for G lobal I ndustry C lassification S tandard , developed by S&P and M organ S tanley C apital I nternational ). (click to enlarge) The First Trust fund’s investment objective: … is to seek investment results that correspond generally to the price and yield, before fees and expenses, of an equity index called the StrataQuant® Materials Index [STRQMT]. .. This is an: … enhanced index developed, maintained and sponsored by the NYSE Euronext or its affiliates which employs the AlphaDEX stock selection methodology to select materials stocks from the Russell 1000 Index .. The AlphaDEX methodology , as the name suggests will identify index components with the greatest potential for capital appreciation. In plain speak, the fund will weight companies in the sector which are performing better than the average company in the sector. So instead of just trying to just replicate the index, it weights its holdings more towards the best performing stocks. (click to enlarge) Observe though that both funds have performed similarly in both good and bad market cycles, but interestingly, the Guggenheim fund conservatively equally weights its holding whereas the First Trust Funds weights slightly more towards risk. The Guggenheim Fund has a far more simple subsector allocation construction, five in all and then most heavily weighted in Chemicals at 57% of the fund’s total holdings. The First Trust fund allocates among ten subsectors, also most heavily weighted in Chemicals, 34%, but also includes an allocation for Aerospace and Defense, 5%, normally part of the Industrial Sector. (click to enlarge) (data from First Trust and Guggenheim) Both companies, as might be expected, have holdings in common; 21 in all. These are listed by First Trust’s weightings; (since Guggenheim equally weights): Holdings in Common Name and Symbol FXZ Weighting SEALED AIR (NYSE: SEE ) 3.47% MARTIN MARIETTA (NYSE: MLM ) 3.12% VULCAN MATERIALS (NYSE: VMC ) 3.03% NEWMONT MINING (NYSE: NEM ) 2.70% The MOSAIC (NYSE: MOS ) 2.61% NUCOR (NYSE: NUE ) 2.42% LYONDELLBASELL (NYSE: LYB ) 2.26% ALOCA (NYSE: AA ) 2.25% DOW CHEMICAL (NYSE: DOW ) 1.89% SHERWIN-WILLIAMS (NYSE: SHW ) 1.89% EASTMAN CHEMICAL (NYSE: EMN ) 1.86% CF INDUSTRIES (NYSE: CF ) 1.65% BALL CORP (NYSE: BLL ) 1.24% AIRGAS (NYSE: ARG ) 1.18% E.I. du PONT de NEMOURS (NYSE: DD ) 1.11% WESTROCK (NYSE: WRK ) 0.76% ECOLAB (NYSE: ECL ) 0.68% AIR PRODUCTS & CHEMICAL (NYSE: APD ) 0.65% PRAXAIR (NYSE: PX ) 0.58% INTL PAPER (NYSE: IP ) 0.56% PPG INDUSTRIES (NYSE: PPG ) 0.53% Data From First Trust and Guggenheim As a general rule, the investor should take the time and trouble to compare the holdings of any ETFs in the same asset class for a reason exemplified here. Of the 28 holdings of the Guggenheim Fund, only 7 are not in common with the First Trust fund. Of those 7, four are in the Chemical subsector, 2 in Containers & Packaging and one in Metals and Mining. Further, as mentioned above, the Guggenheim fund seems rather heavily weighted in Chemicals compared to the First Trust fund; 57.06% vs. 34.09%. In Containers & Packaging the Guggenheim fund is slightly more weighted than Firsts Trust; 18.17% vs. 13.25%. First Trust is a little more weighted in Metals and Mining; 14.23% vs. 20.10%. Lastly, by applying some simple arithmetic, the average weighting of the First Trust’s holding which are not in the Guggenheim fund is just over 2%. The equally weighted unadjusted Guggenheim holding averages 3.57%. The point being that Guggenheim fund is mostly contained in the First Trust fund in terms of holdings, similar in allocation and reasonably close in average weighting. Also as noted above, the First Trust fund has two Aerospace & Defense holdings, 4.69%; a subsector more properly defined as an Industrial subsector. One is Hexcel Corporation (NYSE: HXL ) and the other is Precision Cast Parts (NYSE: PCP ) . In the case of these two companies, the sector to which it belongs just might be a matter of perspective since both companies manufacture specialized materials . Hexcel manufactures: … everything from carbon fiber and reinforcement fabrics to pre-impregnated materials… …and honeycomb core, tooling materials and finished aircraft structures … Precision Cast Parts, as the name implies, manufactures precision and complex casting using high performance nickel and titanium alloys. Hence, although classified as Aerospace and Defense companies, they do produce materials used in industry so are appropriate holdings for a materials fund. Fund and Inception Expense Ratio 1 Year Return 3 Year Return 5 Year Return TTM Yield P/E 3 Month Average Volume Beta Guggenheim [RTM] 11/1/2006 0.40% -7.48% 11.67% 10.78% 1.54% 17 12020 1.09 First Trust [FXZ] 5/8/2007 0.70% -11.43% 9.36% 10.65% 1.57% 17 85131 1.08 (Data from YaHoo!, Guggenheim and First Trust) So what it boils down to is this. RTM is investing conservatively in this volatile sector. FXZ may be viewed as an extension of RTM, with the opportunity for capital appreciation. However, in doing so its accepting a little more risk in this volatile sector. Both are good choices, but the decision of which to choose depends on the risk tolerance of the investor. Having described both funds, the original point must be reiterated: Is this the time to buy into the Material Sector? By referring to the included price divided charts, it is evident that both funds are well off their lows, both lows having occurred in the recession year of 2008. Hence both funds appreciated during the recovery years, in particular those years for which emerging market nations created a seemingly insatiable demand for materials. If those emerging market nations are correcting towards a more sustainable growth rate, then the Materials sector correction may not yet be over. However, this is precisely what is meant by the ‘business cycle’. Eventually, excess supply will be worked down and production capacity will adjust accordingly so that supply and demand will again come into balance. Hence, for a risk tolerant individual investor, a gradual accumulation in the materials sectors, in particular, by patiently dollar cost average in over a long period of time will put the investor in an advantageous position to be able to take advantage of the next, inevitable, up cycle and put to the test the old adage, buy low, sell high.