VAW Is A Great Idea, But The Portfolio Is Not Optimized For The Lowest Risk In The Sector
Summary VAW has a great expense ratio that makes it seem appealing at first glance. When I get into the holdings, I have to question their use of FCX rather than combining RIO or BHP with XOM to replicate mining and oil. With a weak dividend yield, high volatility, and high correlation to the S&P 500, I don’t see a long term holding. The ETF may be a solid option for making short term bets on the direction of the sector. The Vanguard Materials ETF (NYSEARCA: VAW ) offers investors a concentrated sector exposure. The holdings are fairly concentrated within the portfolio, but it is a Vanguard fund with a .12% expense ratio which makes it worthy of consideration Does VAW provide diversification benefits to a portfolio? Diversification benefits are primarily a factor of correlations and variance of returns. Looking back to January 2004 the correlation between VAW and the SPDR S&P 500 Trust ETF ( SPY) was 88% and the volatility for VAW was substantially higher at 25.4% compared to 19.4%. Due to the high correlation and high variance, it is not feasible to use VAW to reduce the risk at the portfolio level unless the starting level of risk was exceptionally high. If the core holding in the portfolio is representing the S&P 500 or the a broad market index, the position in VAW increases the total volatility. Yield & Taxes The distribution yield is 1.86%. That is not high enough to be considered for a dividend growth investor, but the volatility would have made this portfolio less desirable for those dividend growth investors and retirees anyway. Market to NAV The ETF is at a .01% discount to NAV currently. Premiums or discounts to NAV can change very quickly. Liquidity is not terrible, but an average volume around 60,000 shares is not as high as investors might be expecting for a Vanguard fund. Largest Holdings The chart below shows the top 10 holdings: (click to enlarge) The diversification within the ETF is not very strong if we are simply looking at the percentage of the portfolio in each company. On the other hand, if we look at the operations of the individual companies the picture changes materially. For instance, Freeport-McMoRan (NYSE: FCX ) is in my portfolio and regularly helps me lose money. I’m not too happy about that last sentence either, but the portfolio values don’t lie. Freeport-McMoRan is heavily invested in copper mining and oil drilling. The other companies offer investors very different exposure. While the fund is concentrated on the “Materials” sector, the individual companies are still fairly different. If the intent was to own a mining company, I’m a little surprised that Vanguard did not choose to hold shares in a more stable mining company such as BHP Billiton (NYSE: BHP ) or Rio Tinto (NYSE: RIO ) since they both have more diversified mining portfolios and lower cost operations. I assume they did not select Freeport-McMoRan for the oil exposure because they could have picked a much more stable like Exxon Mobile (NYSE: XOM ) if they were trying to include oil exposure. Volatility Comparison To show how much more volatile FCX is compared to using a combination of Rio Tinto and Exxon Mobil, I pulled the following chart from Investspy: (click to enlarge) For comparison sake I set the weight on FCX to 50% and the weights on RIO and XOM to 25% each. While Rio Tinto and Freeport-McMoRan had similar levels of volatility over the sample period, Rio-Tinto would have given the mining exposure with a smaller allocation so the oil exposure could be picked up by XOM. In this simple example FCX would have contributed 61.5% of the risk and XOM and RIO would have combined to contribute only 39.5%. This is a function of XOM simply being a much safer play for including oil exposure in the portfolio. If the oil exposure is not wanted, then the use of Freeport-McMoRan feels pretty strange. Conclusion VAW has a great expense ratio but it simply brings too much volatility for having such a high correlation with the S&P 500. When it comes to selecting companies for the portfolio, it seems like part of the risk stems from selecting companies that are riskier than necessary for creating the desired exposure. I’d rather see VAW modify the portfolio to get the “materials” sector exposure with as little volatility as possible. As it stands, VAW seems like a more useful ETF for making bets on sector movements than as a long term tool for generating wealth with the lowest level of risk possible for the expected returns. Disclosure: I am/we are long FCX. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.