Rare Earth Metal Shortage Could Sink These Three ETFs

by on July 19, 2010 | ETFs Mentioned:

While most investors are relatively familiar with metals such as gold and copper, few know anything about an increasingly vital group of resources known as “rare earths.” As the name suggests, these metals are very scarce, but are needed for a variety of modern technologies ranging from alternative fuels to consumer electronics to defense and security systems. As demand for these modern goods has surged in recent years, it has put a strain on existing rare earth supplies. Historically, the chief supplier of rare earth metals to the U.S. was China, but that arrangement has been called into question as the Asian superpower continues to expand and Beijing has decided to keep more home grown resources within the confines of the Great Wall.

A huge step in this policy came earlier this month as China’s Ministry of Commerce announced that foreign shipments of rare earth metals came in at just less than 8 metric tonnes, a cut of over 72%. This huge drop is likely to drive up prices for a variety of goods, and could lead to supply shortages in the very near future. The United States Magnetic Materials Association (USMMA), which represents high-performance magnet producers and suppliers, warned of “impending shortages“of rare earth materials needed to support domestic manufacturing, noting that China’s shrinking export quota “should serve as a huge red flag for U.S. government officials studying this issue.”

Since the metals are so crucial to a variety of industries, a shortage could ripple throughout the U.S. economy, hitting rare earth metal-dependent sectors particularly hard. Below, we profile three ETFs to watch as this drama plays out  [also see China Export Ban Could Sting ETFs].

iShares Dow Jones U.S. Aerospace & Defense Index Fund (ITA)

Rare earth metals are highly valued in defense and security applications due to their light weights. ITA tracks the Dow Jones U.S. Select Aerospace & Defense Index, a benchmark that measures the performance of the aerospace and defense sector of the U.S. equity market. A recent report from the U.S. Department of Defense emphasized the value of these metals to the military, noting that rare earth elements form a currently irreplaceable part of devices such as lasers, radar, missile-guidance systems, satellites and aircraft electronics. Moreover, many military systems also rely upon commercial computer hard drives that use rare earth magnets, including the navigation system for the M1A2 Abrams battle tank, and a new hybrid electric drive in the works for the Navy’s DDG-51 destroyers.

ITA is heavily invested in some of the United States’ largest defense contractor companies, with large allocations going toward firms such as United Technologies (8.2%), Boeing (7.8%), and General Dynamics (6.1%). ITA is up more than 20% over the past 52 weeks it is down slightly far in 2010 and has posted a loss of 8% over the past month [also read Boeing Evades Competition, Puts Defense ETFs In Focus].

PowerShares WilderHill Clean Energy Portfolio (PBW)

Many of the newest green innovations have been promoted as clean alternatives to fossil fuels. However, these “clean” technologies require massive amounts of metals and extensive mining operations to supply complex technologies [also see the Definitive Guide To Clean Energy ETFs]. PBW tracks the WilderHill Clean Energy Index, a benchmark designed to focus on greener and generally renewable sources of energy and technologies that facilitate cleaner energy, two sectors that are susceptible to the ups and downs of the rare earth metals market.

PBW invests in 55 securities in total and has heavy weightings in LED component maker Rubicon Technology (3.5%), OLED pioneer Universial Display Corp (3.5%), and solar cell maker ReneSola (2.8%). The fund also offers good levels of diversification away from giant cap securities, holding just over two-thirds of its assets in small and micro cap companies. The fund is down about 10% over the past year and has lost more than 20% so far in 2010. PBW could be in for even more pain in the near future if nothing is done to rectify the rare earth metal shortage. “If the United States is to become a leader in clean energy technology, it needs a reliable domestic rare earths supply chain,” USMMA president Ed Richardson said.

Technology Select Sector SPDR (XLK)

XLK is a broad technology fund that invests in a variety of companies likely to be negatively impacted by a shortage of rare earth metals. In terms of sectors, XLK is heavy in hardware firms (50%), with another big allocation (19%) to software firms. Among the top holdings, Apple (11.2%), IBM (7.8%), and Cisco (6%) are good examples of companies likely to be impacted by a shortage, since many of their key products thrive on these metals. “Without the powerful magnets developed using neodymium, makers of mobile phones and mp3 players would not have been able to carry out extensive miniaturization,” says AndrĂ© Diederen of the Dutch research institute TNO [also see Nine Twists On Sector ETF Investing].

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Eric is long ITA and PBW.