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Cheap Exposure to U.S. Consumer Discretionary Stocks

This exchange-traded fund is one of the best bargains in the consumer cyclical Morningstar Category.

Robert Goldsborough, 02/12/2016

Consumer Discretionary Select Sector SPDR XLY offers investors market-capitalization-weighted exposure to firms in the S&P 500 that rely on discretionary consumer spending, such as Amazon.com AMZNHome Depot HDWalt Disney DISComcast CMCSA, and McDonald's MCD. This low-cost, highly liquid, market-capitalization-weighted exchange-traded fund contains retail, restaurant, media, apparel, luxury goods, automobile, and leisure firms and is a bet on consumer spending. However, investors interested in this ETF should beware. Consumer discretionary firms have a consistent history of outperforming in the early stages of a business cycle and underperforming late in a business cycle. So this certainly is not a fund to own if one believes that the U.S. economy is headed toward a recession.

Because of its narrow focus and sector concentration, this ETF is best treated as a tactical satellite holding to complement a diversified portfolio. It's suitable for investors looking to bulk up their exposure to consumers' cyclical behavior, which tends to be tied to employment rates, consumer confidence, and income.

Sector SPDR ETFs are very high-quality because they draw from the S&P 500 and have a very large-cap tilt. The firms they hold also are high-quality because they have durable competitive advantages and strong profitability.

Consumer discretionary firms are more volatile than the broader market. During the past 10 years, this ETF has had a standard deviation of 18.4% compared with the S&P 500's 15.1%. That places this ETF between two large and competing consumer discretionary ETFs. During that same period, iShares U.S. Consumer Services IYC had a standard deviation of 16.1%, while the broadest and most diversified fund, Vanguard Consumer Discretionary ETF VCR, had a 19.2% volatility of return. Unlike the other two funds, IYC holds nondiscretionary retailers, which as a result keeps its volatility relatively lower.

Fundamental View
Despite recent stock market declines, the University of Michigan's consumer sentiment index remained firm in January 2016, registering a reading only slightly below a December 2015 level that had been been at its highest since mid-2015. Lower inflation was a key contributor, even as the U.S. Federal Reserve sought to accommodate a higher inflation rate via its December 2015 interest-rate hike. Consumers presently are concerned about a slowdown in growth that could mean slightly higher unemployment by the end of the year. Morningstar's director of economic analysis, Robert Johnson, forecasts gross domestic product growth of 2.0% to 2.5% in 2016, with employment growth of an average of 220,000 jobs per month (1.8% to 2.0%) and inflation growth of 2.2% to 2.4%. He also anticipates solid gains in consumer spending, with consumption up by 2.5% to 3.0% on an inflation-adjusted basis.

The shift to online shopping is accelerating. Poor retail performance on Black Friday in 2015 was offset by online gains throughout that weekend. Meanwhile, Amazon.com has continued to boost its fulfillment capabilities while also remaining a formidable competitor from a pricing standpoint. Some traditional retail business models, such as home-improvement and auto-parts retail, have characteristics that insulate them from e-commerce competition, such as valuable salesperson help, immediacy of need, and the specialized nature and diversity of products. Other areas of retail, such as toys, office supplies, and consumer electronics, should expect to see continued price compression as consumers shift to e-commerce.

Although almost all of XLY's holdings are U.S.-based, many of these firms have significant operations overseas. Amid macroeconomic worries in China, many investors fear companies' prospects for selling goods to China. However, Morningstar's equity analysts believe that the high end of consumption in China--middle- and upper-income consumers--can outpace the overall Chinese economy in the long run. Morningstar's analysts believe this can happen owing to increased investment in private businesses, saving rates and increased access to credit, increased government share of social welfare and healthcare costs, better investment returns for the middle class, and further returns for China's upper class.

Media firms make up 24.5% of XLY. However, very little of XLY's media stake is invested in publishing and TV companies like News Corporation NWSA. Instead, XLY holds a raft of entertainment firms and cable network owners, such as Walt Disney, Twenty-First Century Fox FOXA, and Viacom VIAB, as well as cable and satellite system firms such as Comcast and Time Warner Cable TWC. Network choices and content selection will drive entertainment firms and cable network owners' success. As new firms enter the TV market, video on demand and subscription video on demand should steadily grow in importance as these entrants innovate around television distribution. Firms best positioned for success are those with strong production studios in both film and TV, along with a deep content library. As the bundle evolves, the most-watched networks should survive and even flourish. Also poised to succeed are firms with exposure to faster-growing international markets where high-quality Internet access is less pervasive, providing a longer runway for traditional distribution models. Many of this ETF's holdings are those poised to succeed.

Portfolio Construction
XLY follows a full replication strategy and holds every consumer discretionary stock in the S&P 500 at market-cap weightings. The sector constitutes about 12.5% of the broader S&P 500. Sticking to S&P 500 companies provides an initial screen for quality, as holdings must meet the standards of the S&P selection committee. The fund makes dividend distributions on a quarterly basis. As one of the Select Sector SPDR ETFs, XLY follows S&P's rules for index construction. S&P has the flexibility to make changes to the S&P 500 at any time as needed, with no regularly scheduled reconstitution. Then, a company's stock is assigned to a particular Select Sector index on the basis of its sales and earnings composition and on the sensitivity of its stock price and business results to the common factors affecting other companies in each Select Sector index. Under the rules, every constituent in the S&P 500 is assigned to a particular Select Sector index, and no company can be included in more than one index.

Fees
The fund's 0.14% expense ratio is low, although there are cheaper alternatives. Vanguard Consumer Discretionary ETF charges slightly less, at 0.10%, and Fidelity MSCI Consumer Discretionary Index ETF FDIS charges 0.12%. XLY lagged its benchmark by 16 basis points during the past year. This is the fund's estimated holding cost. This calculation includes transaction costs, sampling error, and share-lending revenue.

Alternatives
For comparable exposure to discretionary consumer spending, Vanguard Consumer Discretionary ETF VCR (0.10% expense ratio) is better diversified and cheaper with a 0.10% fee and a 0.07% estimated holding cost. It holds 383 firms. A pricier ETF with slightly different exposure is iShares U.S. Consumer Services IYC (0.43% expense ratio), which unlike XLY and VCR holds some defensive retailers like Wal-Mart WMT.

Fidelity MSCI Consumer Discretionary ETF FDIS is an inexpensive ETF, with a 0.12% fee. However, FDIS has fewer assets than competing ETFs, which could make it more expensive to trade. FDIS tracks a slightly different index--the MSCI USA IMI Consumer Discretionary Index—while VCR tracks the MSCI US Investable Market Consumer Discretionary 25/50 Index. The indexes are very similar, with nearly identical weighting schemes, similar numbers of holdings, and minimal differences in holdings. Fidelity customers with a minimum balance of $2,500 can buy FDIS commission-free. Fidelity may charge a trading fee to those who sell after a short-term period (30-60 days); customers who own for longer periods are not subject to any such fee.

IShares Global Consumer Discretionary RXI (0.47%) offers international consumer discretionary exposure but has overweightings in the automotive industry; RXI's top 25 holdings include Toyota TM, Daimler, Ford FGeneral Motors GM, and Honda HMC. Auto manufacturers, retailers, and component makers make up 23% of RXI's assets, compared with those industries' 9%-12% weightings in VCR and XLY. IYC holds no auto-related firms.

Nevertheless, the performances of the above-mentioned ETFs are very highly correlated.

Disclosure: Morningstar, Inc.’s Investment Management division licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index. 

Robert Goldsborough is an ETF Analyst at Morningstar.
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