Basic Materials ETFs: Up on Demand

ETFZone

Increased demand for raw materials and a surge in manufacturing activity has made basic materials ETFs into market darlings. But manufacturing activity typically increases when economies emerge from a recession. Now the recession is a year behind us. Is manufacturing growth strong enough to support further outperformance of materials ETFs?Basic materials ETFs hold companies producing chemicals, industrial metals, timber and agricultural products. They control raw materials essential to production. The sector is highly cyclical. When manufacturing collapsed in the final quarter of 2008, materials ETFs lost 50% of their value. Most of those losses have since been reversed- but not all.The chart below shows this. It compares the 5-year performance of the Materials Select Sector SPDR (NYSEArca:XLB - News) and the iShares Dow Jones Basic Materials (NYSEArca:IYM - News).with the benchmark Standard and Poor's Depositary Receipts (NYSEArca:SPY - News).

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The chart shows the volatility and cyclicality of the materials sector. Basic materials ETFs outperformed through the fall of 2008, before tumbling. The resurgence of global demand in the second half of 2009 started the rebound. Basic materials ETFs beat the S&P by a 2:1 margin in 2009, mostly on the back of government stimulus and demand from the Chinese.The structure of the industry contributes to its volatility. Significant fixed assets ensure a high cost to setting up an operation in the sector. This provides barriers to entry for competition and allows companies a measure of monopoly pricing. In a growing economy with demand on the upswing, raw material companies exert more control. Profits skyrocket. But this structure is also a curse. Operations are expensive and companies tend to be so far upstream in the production process that faltering demand anywhere along the production chain threatens pricing power. When demand falters, profit disappears. Some companies even lose money.Demand is all-important. How is the demand for basic materials assessed? Most elastic demand for basic materials comes from the manufacturing sector. The ISM Manufacturing Index is based on a survey of purchasing managers in manufacturing and monitors inventories, production, deliveries as well as new orders. The ISM Manufacturing Index slumped dramatically in the last quarter of 2008, and has since reversed. The chart below from the St. Louis Fed shows the 5-year ISM Manufacturing PMI composite Index.

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The chart An ISM above 50 indicates growth in the sector. Below 50 indicates contraction. The shaded area indicates the U.S. recession. As the chart shows, manufacturing was steady before September of 2008 when it hit a wall. ISM fell to below 35 in Q4 2008. ISM has been above 55 for most of 2010. ISM for October 2010 is 56.9%, indicating healthy growth.Demand for raw materials comes in part from the fast-growing economies in Asia, particularly China. Over the last decade, China's strong economy has shifted the demand curve for basic materials. Today, China's demand is bigger than ever. Flush with cash, state-owned Chinese companies are actively purchasing basic materials operations. Basic material and the companies that produce them have additional attraction for China. Unlike treasuries bonds and other assets China has accumulated, basic materials are attractive because like other commodities, raw materials tend to hold up well in the event of inflation. As Barrons has reported recently, China is scouring the world-- from Australia to Africa- for materials. They are buying industrial assets, they are doing infrastructure deals with governments. Where they cannot buy the assets or the companies outright, they are buying big stakes.Though U.S. manufacturing growth may slow in the next couple years, basic materials ETFs are a good asset as an inflation hedge and in light of the growing world-wide demand for materials and materials assets.Following is a list of Basic Materials ETFs:Standard Index:* Materials Select Sector SPDR Fund (NYSEArca:XLB - News)* Vanguard Materials ETF (NYSEArca:VAW - News)* iShares Dow Jones U.S. Basic Materials Sector Index Fund (NYSEArca:IYM - News)* iShares S&P Global Materials Sector Index Fund (NYSEArca:MXI - News)International:* WisdomTree International Basic Materials Sector Fund (NYSEArca:DBN - News)* SPDR S&P International Materials Sector ETF (NYSEArca:IRV - News)Fundamental:* Powershares Dynamic Basic Materials Sector Portfolio ETF (NYSEArca:PYZ - News)* First Trust Materials AlphaDEX Fund (NYSEArca:FXZ - News)Sector Specific:* Market Vectors Steel ETF (NYSEArca:SLX - News)* Global Steel Portfolio ETF (NasdaqGM:PSTL - News)Short/Leverage:* Ultra Basic Materials ETF (NYSEArca:UYM - News)* UltraShort Basic Materials ETF (NYSEArca:SMN - News)Jonathan Bernstein has been writing about ETFs since 2003 and is the author of Sector Trading: A Year in Exchange Traded Funds.

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