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

Retail HOLDRS RTH
A more defensive retail ETF is Retail HOLDRS, a concentrated product from Merrill Lynch that consists of just 18 retailers. RTH is suitable for investors who are skittish about the consumer but still interested in some retail exposure. In particular, discount retailers, led by a nearly 19% investment in Wal-Mart, comprise more than 27% of the fund, while home-improvement retailers make up almost 20% and drugstores account for another 11%. As a result, RTH would make a fine choice for investors looking for significant ETF exposure to Wal-Mart or to the home-improvement retailers. In addition, RTH offers investors exposure to the online retailing titan Amazon.com AMZN, which makes up almost 12% of the fund. RTH charges no expense ratio; instead, it levies a very inexpensive custodian fee that translates to what would be an annual fee of perhaps 0.02% to 0.04%. RTH is trading slightly below its fair value.

Some concerns about RTH include the fact that because less of its portfolio is cyclical, there is less potential for a massive rebound. Plus, the home-improvement retail exposure effectively gives RTH some exposure to the ups and downs of the housing sector. Also, although RTH has some exposure to online shopping (chiefly through Amazon, but also through small positions in Best Buy BBY and Gap GPS), there are other funds out there like Internet HOLDRS HHH (where Amazon.com is 43% of assets) with much greater exposures to online retailers. RTH does not own luxury retail, where some of the most explosive growth is forecasted for this holiday season. Ultimately, however, RTH stands to benefit if the retail industry exceeds expectations this holiday season, allowing a rising tide to lift all boats.

PowerShares Dynamic Retail PMR
This tiny and thinly traded ETF is a 30-stock portfolio with equal allocations to large-cap, mid-cap, and small-cap names. The fund uses quantitative analysis in an effort to outperform traditional market-cap-weighted ETFs like XRT. The fund charges the highest fee of any retail ETF (0.60% expense ratio), but it has earned that fee for long-term investors, significantly outperforming the S&P 500 since its inception. It also has returned more than 23% for the year to date, or almost double the S&P 500's return in 2010.

An equally-weighted fund that rebalances quarterly, PMR tracks an unorthodox benchmark that selects and ranks stocks using a 25-factor proprietary model that ranks retail stocks by size and by scores based on fundamental growth, valuation, risk, and investment timeliness.

Some of PMR's holdings seem like they are not truly retail names (such as Amerco UHAL, Liquidity Services LQDT, and Wesco Financial WSC), but, by and large, the fund labors to invest close to two thirds of its assets in consumer discretionary retailers and another 20%-plus in consumer staples retailers like Walgreen WAG and Kroger KR.

PMR clearly has generated some impressive results since it began trading in 2005 and normally would be an appropriate way to play the retail space. However, PMR currently trades above Morningstar's fair value, suggesting that any upside is limited unless consumer spending this holiday season substantially exceeds expectations. Also, because PMR is so thinly traded, investors are advised to keep a close eye on bid-ask spreads and to always use limit orders.

Other Retail ETF Options
Beyond the three pure-play retail ETFs, investors can consider two other ETFs with substantial retail weightings. One, iShares Dow Jones U.S. Consumer Services IYC, has close to half of its assets invested in names that are classified as retail, including Internet and catalog retail, multiline retail, specialty retail, and food and staples retail. IYC also trades above Morningstar's fair value, however, suggesting limited upside potential.

Also, Internet HOLDRS, as mentioned above, could be a way for investors to play online retail in the form of Amazon.com and eBay EBAY, given that the two companies together comprise more than 63% of HHH's assets. At the same time, HHH offers significant concentration risk, to the point, in fact, that investors may be better off just owning Amazon or eBay stock.

Robert Goldsborough is an ETF analyst with Morningstar.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), Claymore Securities, First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.