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Is the Materials ETF in Trouble?

Zacks Equity Research

The start of the New Year also led to the beginning of the much awaited U.S. recovery. The economy started the period on a high note and a solid first quarter performance is a testament to this bullish trend (Top Performing ETFs of the First Quarter).

Indeed, the S&P 500 recorded strong gains in Q1 and remains at elevated levels. S&P 500 registered a 10% rise in the first three months of the year in spite of new worries in the euro-zone debt crisis.

Panic initially spread in the market following the Cyprus issue but with the distressed euro-zone member opening its banks, tensions finally eased.  This once again set the platform for S&P 500 to push into record territory.

The strong momentum of the S&P 500 since the start of the year indicates that the bull may be back in the market. A number of sectors have performed remarkably well in the year-to-date period, thanks to the market optimism (Four ETFs to Buy on the Market Pullback).

In fact, many of the nine main sectors of the S&P 500 have posted remarkable growth year to date, suggesting that the positive sentiment is pretty widespread throughout the equity world. However, one sector which remains impervious to the overall bullish sentiment and strength in the market is the material sector.

XLB in focus

When almost all the SPDR exchange traded funds (ETFs) have exhibited a strong performance in the year-to-date period, Materials Select Sector SPDR Fund (XLB) which has been designed to tap the broad material sector has fallen far behind. When SPDR S&P 500 (SPY) returned 9%, the fund could just manage to provide investors with a gain of 1.62% in the year-to-date period (5 Sector ETFs Surging to Start 2013).

The fund’s asset base of $2.8 billion is spread across holdings of 32 securities. Monsanto is the largest holding in XLB, accounting for 11.7% of the ETF. Other top holdings include Du Pont de Nemours Co with 9.7% and Dow Chemical with 7.8%. The fund appears to be quite popular as indicated by its trading volume of more than 14 million shares a day.

The fund relies heavily on the chemical sector in which it has assigned an asset base of 71.5%. Metals & mining also gets a double-digit allocation of 16.56%. XLB charges a fee of 18 basis points annually.

Behind the Slumping Materials ETF

It appears that the industrial metals sector continues to suffer from unfavorable supply and demand conditions in 2013.  Metal producers are subject to cyclical fluctuations in prices, general economic conditions and end-user markets. The tepid global economic growth outlook has emerged as a major headwind for the global metal industry (Time to Sell the Steel ETF?).

Moreover, cost inflation in the sector is expected to be a headwind for metal and mining companies over the next several years, driven by a number of factors, such as, labor, energy, ore grades, currencies, supply constraints and taxes. Global economic uncertainties, softening commodity prices and higher input costs are increasing the pressure on company margins.

Also, growth in the emerging markets, particularly China and India, was a major driver of metals demand over the last few years. However, of late, demand in China has slowed down.

China's recent $150 billion infrastructure stimulus has helped improve the sentiment somewhat and holds promise for the metals and mining industry going forward.

Additionally, the U.S. coal industry may continue to face a tough time in 2013 as well. Coal is facing tough competition from natural gas. With enormous supply and comparatively lower prices for U.S. natural gas, many utilities are preferring natural gas to coal (Are Coal ETFs Back on Track?).

On the other hand, slumping gold prices have greatly impacted the sector in 2013. With dollar and risky investments gaining strength, gold which is regarded as a safe haven, has been losing its shine. In fact, 2013 has seen a major fall in the prices of gold.

This is evident from the year-to-date performance of gold ETFs. SPDR Gold Shares (GLD) has lost 6.97% so far this year while the loss at iShares Gold Trust (IAU) stands at 6.94%.

A Look at Other Material ETFs

It is just not XLB which has been exhibiting poor performance in the material space. There are some others as well which have been victims of the slowing material sector (The Guide to Broad Metals and Mining ETFs).

In this context, SPDR S&P Metals and Mining ETF (XME) turned out to be the biggest disaster in the space with a year-to date loss of 16.73%. Another ETF which falls in the list is Market Vectors Coal ETF (KOL) which lost about 12% over the same period.

Bottom Line

Thanks to this turmoil, we currently have a Zacks ETF Rank of 3 or ‘Hold’ on XLB, suggesting an in-line outlook over the next 12 months for the fund. So, we are looking for sluggish trading to continue in this materials ETF, although with its low risk rating we expect volatility levels to be rather small going forward.

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