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The materials sector thrives when the global economy is growing.
China released a stimulus package that includes lower reserve requirements for banks, lower interest rates, measures to encourage stock buybacks, homebuyer relief, and more.
Chinese stocks and exchange-traded funds (ETFs) — many of which have been underperforming the S&P 500 by a wide margin in recent years — surged in response to the news. But so did the Vanguard Materials ETF (VAW -0.40%)which reached a new intraday all-time high on Friday.
Here’s a primer on the ETF and why it could be worth buying now.
Image source: Getty Images.
The supporting cast of economic growth
Top players in the materials sector are companies like Linde, Sherwin-Williamsand Ecolab. These companies are big, but simply aren’t on the same level as giants in sectors like technology, financials, or healthcare. The sector contains many mid-cap and small-cap companies as well. A company like Louisiana-Pacific may not light up on most investors’ radars. But the building products and equipment company is an industry leader and has seen its market cap increase several times over in the last decade.
Of the 11 stock market sectors, the materials sector has the lowest weighting in the S&P 500 at just 2.2%. But don’t let its tiny influence on the S&P 500 distract you from the sector’s importance for global economic growth.
Despite its lack of glitz and glam, the materials sector acts as the picks and shovels of economic growth. It includes chemicals companies; miners for steel, copper, silver, and gold; packaging, paper, and plastics companies; construction materials manufacturers; fertilizer producers; and more.
Like other cyclical sectors, materials are highly dependent on commodity prices. Oversupply can lead to lower prices and weaker margins. But higher demand can help justify supply increases and capital investment.
Higher interest rates can discourage capital investment and slow economic growth, weakening global demand for materials. So the Federal Reserve’s decision to lower interest rates and China’s stimulus package are potentially great news for the sector — especially given China’s manufacturing-heavy economy.
ETFs have advantages for commodity-dependent sectors
The Vanguard Materials ETF has an expense ratio of just 0.1% — or $1 for every $1,000 invested. It also has a minimum investment of $1, making it a convenient way to diversify without committing much capital. The ETF has a price-to-earnings ratio of just 16.6 and a yield of 1.6% — which is a considerably lower valuation than the S&P 500 and a slightly higher yield.
There are certain market sectors where ETFs can be particularly effective tools for achieving diversification, and materials is one of them. The Vanguard Materials ETF is a simple way to invest in higher demand for the chemicals and commodities that power the modern economy. Unless you closely follow commodity prices and the materials sector, the competitive advantages of, say, Dow Inc. compared to LyondellBasell may not be apparent. So the fund’s over 100 holdings are a good choice for investors who are interested in general economic growth and higher consumption — not just one industry like copper or chemicals.
In this vein, the materials sector is similar to the utilities sector, where the leading players have footholds in specific geographic regions. Investing in the Vanguard Utility ETF grants exposure to electric, water, and gas utilities across multiple geographies instead of betting on just a few players.
In sum, ETFs can be great tools for investing in commodity-focused sectors like materials, utilities, or energy.
A worthwhile ETF for risk-tolerant investors
Like any sector, some materials companies stand out as especially good buys. Still, most investors may be better suited with an ETF to ensure exposure to several industries and not just one sector aspect.
The low cost profile and low minimum investment requirement for the Vanguard Materials ETF makes it the perfect fund for investors to consider if they are optimistic that lower interest rates will help accelerate growth while also allowing economic powerhouses like the U.S. and China to avoid recessions.
That said, it’s worth understanding that materials stocks can be volatile during periods of high uncertainty or economic slowdowns. Over the last five years, the max drawdown of the Vanguard Materials ETF was 41.1% — meaning the ETF fell that much from its high. The max drawdown over the last three years was 25.5% — which doesn’t even include the pandemic-induced sell-off.
In sum, you should only consider the Vanguard Materials ETF if you are comfortable with the sector’s volatile nature.
Daniel Foelber has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Linde. The Motley Fool recommends Ecolab and Sherwin-Williams. The Motley Fool has a disclosure policy.