Investing in the Retail Sector Through ETFs

With a chill in the air, snow on the ground in some parts of the United States, and holiday music playing at every turn, retailers right now have to be wondering if this holiday season's sales numbers will be music--to their ears.

So far, retail numbers have looked rosy. For the past year, consumers have done a great job of deleveraging their personal balance sheets, which has meant that they have had more money in their wallets, and consumer sentiment has been steadily rising. Recent earnings reports from Wal-Mart WMT, Target TGT, and Home Depot HD all have been greater than expected. Black Friday results for 2010 appeared very promising, with the National Retail Federation projecting a 9% increase in spending over that holiday weekend versus Black Friday 2009. On top of all that, online spending has reached new highs, with shoppers shelling out an average of more than $60 per transaction on Cyber Monday--the Monday after Thanksgiving--paving the way for Cyber Monday sales to clear $1 billion for the first time ever.

When all the smoke clears, the retail sector as a whole is expected to see growth of 3.5% to 4% for the full-year 2010, with luxury retail expected to be up even more (in the 6% range). Clearly, shoppers are in a buying mood, although thus far, there have been pockets where retail has been a little weaker--furniture, electronics and appliances, and department stores.

Investors looking for an exchange-traded fund to invest in the retail sector have a few options. There are just three retail-only ETFs, one of which is very thinly traded.

Here, we take a closer look at the retail ETFs, along with our take for investors about the attractiveness of each one.

SPDR S&P Retail XRT
This is the 800-pound gorilla of retail ETFs. As one of the 25 most-liquid ETFs of any kind, XRT is a true bellwether for retail investors, with exposure to more than 60 diverse bricks-and-mortar retailers, the overwhelming majority of which are discretionary in nature. In addition, because the index that it tracks is equally weighted, even really large, big-box retailers like Wal-Mart and Target are precluded from making up a large amount of the ETF. In addition, with an annual fee of 0.35%, XRT is a relatively inexpensive way to play the space.

The SPDR has its drawbacks. Its equal-weighted nature means that it holds mostly smaller-cap companies (81% of the fund's assets are invested in small- and mid-cap firms) and, as such, is far more volatile. It does not own home-improvement retailers like Home Depot and Lowe's LOW. In addition, the fund is a cyclical play, and cyclical firms tend to rally before an economy fully emerges from its slump, making them good vehicles to own in advance of the next resurgence in consumer spending. However, XRT already has risen 35% this year (driven heavily by strength in consumer discretionary retailers like Ann Taylor Stores ANN, Tiffany TIF, Hibbett Sports HIBB, Signet Jewelers SIG, Dick's Sporting Goods DKS, and Abercrombie & Fitch ANF), and the fund now trades above Morningstar's fair value estimate for it. As such, we suspect that much of the good retail numbers that investors have been reading about this holiday season already have been priced into the shares of XRT's underlying holdings. For XRT to outperform in the near term, its underlying companies are going to need to exceed market expectations this holiday season by a substantial amount.

One final note: XRT has the most shares sold short of any ETF, with its percentage recently climbing during the month of November to some shockingly high levels (more than 300% short). Clearly, heavy market sentiment believes that XRT and other retail ETFs are poised for a stumble, making a new investment at XRT at this time a clear contrarian play. Similarly, XRT (or any other overvalued retail ETF) clearly is an option for investors interested in shorting the retail sector as a whole.PAGEBREAK