ETF Showdown: Materials Melee

The materials sector accounts for just 3.5 percent of the S&P 500's weight, making it the third-smallest sector in the broader market index ahead of only utilities and telecommunications. Even with that factoid, there are plenty of materials ETFs for investors to choose from. Including the inverse and leveraged products, there are nearly 60 materials ETFs on the market today. No two materials ETFs are exactly the same, but the major funds tracking producers of basic materials such as DuPont DD and FreeportMcMoRan FCX have a lot in common. The iShares Dow Jones U.S. Basic Materials Sector Index Fund IYM, Materials Select Sectors SPDR XLB and Vanguard Materials ETF VAW are not triplets, but one is not vastly different from the other. These are standard, passively managed cap-weighted funds. That approach has worked well at least in terms of attracting assets. In the case of XLB, the ETF has almost $2.5 billion in AUM. Impressive, but a smaller fund that does things a little bit differently is a worthy competitor to XLB and IYM and VAW for that matter. Just look at how the First Trust Materials AlphaDEX Fund FXZ stacks up against XLB. XLB uses the traditional cap-weighted methodology found in so many ETFs. There is nothing wrong with this approach as it keeps costs down, but it does mean a stock's size is often the most important criteria for inclusion in the ETF. Regarding size, it is not surprising to see Monsanto and DuPont each accounting for 10.4 percent of XLB's weight. Freeport and Dow Chemical DOW combine for 16 percent of the fund's weight. That is four stocks representing a 37 percent of one ETF. The First Trust Materials AlphaDEX Fund, which is just over five-years-old compared to almost 14-years-old for XLB, does things differently. Home to 57 stocks, FXZ devotes no more than 3.2 percent of its weight to any single holding. FXZ has duplicate holdings with XLB such as DuPont, Dow and Freeport. However, the AlphaDEX selection methodology ensures FXZ is much different than XLB. The AlphaDEX methodology is not active management per se, but it does employ quality screens on potential constituents for ETFs such as FXZ. FXZ tracks the NYSE Euronext constructs the StrataQuant Materials Index, which uses the AlphaDEX methodology. That ranks Russell 1000 members on metrics such as three, six and 12-month price appreciation, cash flow, book value, return on assets and others. The stocks are scored and ranked with the bottom 25 percent being tossed aside and the "selected stocks are divided into quintiles based on their rankings and the top ranked quintiles receive a higher weight within the index," according to First Trust. That is how FXZ is put together. Not surprisingly, this way of constructing an ETF is pricy compared to the usual cap-weighted methodology. FXZ has annual fees of 0.7 percent compared to just 0.18 percent for XLB. FXZ is also slightly more volatile than XLB. This is a reward for the elevated volatility and higher fees: Over the past quarter, year and year-to-date FXZ has outperformed XLB by health margins, proving the AlphaDEX methodology is worth considering. For more on materials ETFs, click here.