Getting Back to Basic Materials

These two funds could play quite different roles in a diversified portfolio.
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In the past four months, about seven new exchange-traded funds have been listed that either broadly or narrowly invest in the basic materials sector.

Two of the narrower funds would seem to have a lot in common and may be worth some study, as the sector has begun to retrace the losses from this past summer.

The

SPDR Metals & Mining

(XME) - Get Report

and the

Market Vectors Gold Miners ETF

(GDX) - Get Report

each cover similarly volatile sub-sectors with some overlap in materials.

Despite the similarity of their names, there are actually some big differences between the two, taken in the context of being from the same sector. The correlation of the two funds is only 0.75, which is lower than I would expect. In fact, Market Vectors Gold Miners has a higher correlation to

iShares MSCI Canada

(EWC) - Get Report

at 0.802. (Market Vectors Gold Miners is 49% weighted to Canada, while SPDR Metals & Mining is 100% domestic.)

Market Vectors Gold Miners also has a much higher correlation to gold, as measured by the

streetTRACKS Gold Shares

(GLD) - Get Report

, at 0.831, while SPDR Metals & Mining correlates at 0.582.

You don't need to spend too much time under the hood to see that, even though the names are similar, the funds do have some big differences. Some others include the following:

  • SPDR Metals & Mining has 19% in energy by virtue of owning roughly 4% each in Arch Coal (ACI) - Get Report, Peabody Energy (BTU) - Get Report and three other coal stocks. In contrast, Market Vectors has no investment in energy.
  • SPDR Metals & Mining is 100% domestic, while Market Vectors Gold Miners is only 29% domestic.
  • SPDR Metals & Mining's focus is much broader. It encompasses precious metals (15%), coal and industrial metals, while Market Vectors Gold Miners is 100% precious metals.

As the chart shows, both are volatile. For some context, SPDR Metals & Mining has a standard deviation of 34.92, and Market Vectors Gold Miners is 38.01, while the broader

Materials Select Sector SPDR's

(XLB) - Get Report

standard deviation is only 16.70.

This is potentially an important attribute. While many pundits deride these types of narrow funds, sometimes it makes sense to add volatility within a sector. Funds like SPDR Metals & Mining and Market Vectors Gold Miners provide a way to do that without taking on single-stock risk.

These two funds should be thought of as capturing different effects within the same sector and would play different roles in a diversified portfolio. Market Vectors Gold Miners should offer many benefits of gold exposure -- in terms of more protection against inflation and more protection against true crisis -- without having to study the political ramifications of Bolivia and how it might impact one particular stock.

SPDR Metals & Mining is more of a cyclical play. Generally speaking, industrial metals, especially copper, tend to lead early on in the economic cycle. This time around, the industrial metals have done well throughout the entire cycle, giving some credence to the super-bull market that some believe is under way.

I believe these two funds are different enough that they could both be owned at the same time. However, they would add a lot of volatility to a portfolio, too much for some investors regardless of where we are in the cycle.

Given the longer-term run the materials sector has had, and given that the group has retraced about half of its summer correction, this may not be the ideal time to overweight volatility in this part of the market.

At the time of publication, Nusbaum has XLB as a client holding, although positions may change at any time.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, Ariz., and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback;

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