The Next Big Thing for ETFs

by: Roger Nusbaum

Here's the next big thing for ETFs... well, what I think should be the next biggest thing for the ETF industry anyway.

On Squawk Australia on Tuesday morning (Australia time) a company called Fortescue Metals (FMG in Australia, OTC:FSUMY on the US pinks) made a lot of news because of contract negotiations with China. If you watch CNBC Asia you might have heard of Fortescue before; otherwise, probably not.

Fortescue is one of a zillion, by my count (ahem), of smaller-cap materials companies out there that are not easily accessed by US based investors. As I say smaller-cap or midcap, they may not be that small in their own country, for example Yara International (YAR in Norway, OTCPK:YARIY on the pinksheets) has an $8 billion market cap according to the Businessweek quote page, which is big for Norway but doesn't make it big enough to make a dent in the iShares Global Materials ETF (NYSEARCA:MXI) which some clients own.

Buying MXI or the similar WisdomTree International Basic Materials Fund (DBN) is a reasonable way to build the materials portion of a diversified portfolio, better in my opinion that the Materials Sector SPDR (NYSEARCA:XLB), which is heavier in US chemical companies and which I think is less compelling. If you buy MXI or DBN you are going to get a lot of BHP Billiton (NYSE:BHP), Rio Tinto (RTP), BASF (OTCQX:BASFY) (also a chemical company) and Anglo American (AAUK), which some clients own.

There's nothing wrong with those companies and, by extension, those funds, but there are plenty of other interesting companies in the materials sector out there. You can get a sense of what is out there by looking at the holdings page for each fund, specifically at the names that make up less than 1% of each fund. If you look at the company websites of some of them you will see some interesting things going on.

Even beyond the fund holdings there are interesting stocks; somehow Israel Chemical (ICL in Israel, ISCHY on the US pinks) isn't in either MXI or DBN unless I missed it. The company is not exactly obscure -- it is the second largest holding in the iShares Israel ETF (NYSEARCA:EIS) at 10% of the fund.

You might be thinking, hey, if you can get Israel Chemical through EIS, why doesn't Roger shut his cake hole. This brings up the idea of secondary effects of ETFs or other funds that can be proxies for reducing cap size at the sector level. iShares Peru (NYSEARCA:EPU) is 65% materials so that could be a proxy in this context; the Colombia ETF (NYSEARCA:GXG), not so much, as that fund is heaviest by far in financials.

Perhaps the EG Shares Metals & Mining ETF (NYSEARCA:EMT) should have a seat at this table. It invests in emerging market materials companies. Either of the coal ETFs could also partly fill this role and we haven't even talked about the many smaller, but real, companies in Canada.

My thought with this, though, is accessing a broad swath of second tier (maybe that is a good term) companies from both developed and emerging countries. Funds like this could be a way into to parts of the market that can be difficult to access with individual stocks and that are too small to move the needle in the existing ETFs.

I think the idea of second-tier sector ETFs (or whatever better name anyone can offer) could be applied to quite a few sectors but not all (at least I don't think all of them). I will try to talk this up at the MoneyShow this weekend if any ETF representatives are there, and I also know one or two people that work in the industry so I'll try to reach out to them. If you are a person in the industry reading this and you want to discuss it more please reach out to me and we can chat it up further.