Material Shortcoming in Sector's ETFs

This column was originally published on RealMoney on Oct. 4 at 2:36 p.m. EDT. It's being republished as a bonus for TheStreet.com readers.

My primary focus in my first month on RealMoney has been exchange-traded funds (ETFs), which I believe are great tools to help investors build diversified portfolios. But they are just tools and they have flaws.

Sometimes ETFs are not necessarily the best way to capture a desired effect.

A case in point would be in the materials sector over the last two months.

There are three materials ETFs: iShares Dow Jones US Basic Materials(IYM Quote), Materials Sector SPDR(XLB Quote) and Vanguard Materials VIPERs(VAW Quote).

Over the last two months, all three ETFs have lagged the S&P 500 as their weightings in chemical companies, including DuPont(DD Quote) and Dow Chemical(DOW Quote), have been the driver down due to higher energy prices and exposure to the hurricane-affected part of the country.

Of course, Alcoa(AA Quote) and International Paper(IP Quote) haven't helped much either.

One of the best-performing parts of the entire stock market over the last two months has been the gold-mining stocks. All three materials ETFs have about a 4% weight in Newmont Mining(NEM Quote), but none of them derived much benefit from the move in gold.

The point here is that the materials ETFs only capture and correlate with certain parts of the sector. Anyone trying to build a diversified portfolio with ETFs should understand these limitations. The materials sector ETFs capture chemicals more than anything else. That was a good thing for the month of July, but for August and September it wasn't. For those two months it has been stocks of gold, copper, nickel, iron ore and timber companies that outperformed, and these types of companies are not well represented in XLB, IYM or VAW.

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Material ETFs

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Newmont Mining

Score With Low Correlation

If the commodity bull market is for real, and I believe it is, these three ETFs won't really participate. Capturing this effect will require exposure to anything involving gold and South Africa, Latin America, Australia and copper, to name a few.