Chemical ETFs Not so Toxic

Materials exchanged traded funds with significant exposure to chemicals producers have lagged the broader market year-to-date, but over the past months, a legitimate cyclical rotation has started, boosting some well-known materials ETFs along the way. Some analysts are bullish on the chemicals sub-industry.

“We see the industry overall as having a decent revenue growth outlook of 5%-8% per year for the next several years, accompanied by relatively high profit margins. By and large, we see the major companies within the industry as able to earn above their cost of capital (and above a 10% return on capital) on a sustainable basis over a normal economic cycle,” said S&P Capital IQ in a new research note.

The research firm has three-star ratings on Dow component DuPont (NYSE: DD), Dow Chemical (NYSE: DOW), Air Products (NYS: APD) and Praxair (NYSE: PX).  All four are top-10 holdings in the Materials Select Sector SPDR (NYSEArca: XLB) and combine for 30% of the ETF’s weight. The quartet represented 22.4% of the Vanguard Materials ETF (NYSEArca: VAW) at the end of August, according to issuer data.

While XLB is slightly more expensive at 0.18% per year compared to VAW, investors may want to consider the latter due to its larger allocations to stocks that have been popular with hedge funds in recent months. In July, it was reported that hedge fund manager Nelson Peltz, founder of Trian Fund Management, had amassed a sizable position in DuPont. In August, a similar rumor pertaining to Dow Chemical started after unusual options activity in the largest U.S. chemicals maker was spotted. [Materials ETF Could Get Another Activist Jolt]

Around that time, it was reported that Bill Ackman’s Pershing Square Capital unveiled a $2.2 billion stake in Air Products. Air Products, Dow and DuPont combine for 23.4% of XLB’s weight. VAW’s combined allocation to those stocks is 16.3%.

Still, there is more to the story with chemicals stocks and the relevant ETFs than chasing big-name professional investors.