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ETF Specialist

A Cheap Way to Bulk Up on Consumer Exposure

This low-cost ETF offers a basket of consumer-discretionary firms whose success hinges on consumer sentiment.

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U.S. consumer discretionary firms have outperformed the broader market in 2015. Lower gas prices and higher employment have offset consumers' concerns about anemic real wage growth, higher cost-of-living expenses on items such as rent and health care, and broad stock market weakness. And even recently declining consumer sentiment readings still are well above their levels of a year ago.

Despite recent market uncertainty, U.S. consumers remain generally confident and optimistic. Generally, affluent consumers are showing very strong sentiment, while lower- and middle-income consumers are taking a more measured view. The result is that, thus far this year, consumer discretionary firms largely have held up nicely, meaningfully outpacing the S&P 500.

For investors interested in gaining access to a basket of firms that depend on discretionary consumer spending, one suitable option is  Consumer Discretionary Select Sector SPDR ETF (XLY). This low-cost exchange-traded fund, which holds 86 U.S.-based companies, offers investors exposure to firms in the S&P 500 that largely depend on discretionary consumer spending. The highly liquid, market-capitalization-weighted ETF is fairly concentrated and owns retail firms, restaurants, media companies, apparel and luxury goods companies, automobile manufacturers, and leisure firms. Investors interested in this ETF should beware, however. Consumer discretionary companies 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 that one would want to own if one believes that the U.S. economy is headed toward a recession.

This ETF is best treated as a tactical satellite holding to complement a diversified portfolio and 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. Over the past 10 years, this ETF has had a volatility return of 18.1%, compared with the S&P 500's volatility return of 14.7%. That places this ETF between two large and competing consumer discretionary ETFs. Over that same period,  iShares US Consumer Services (IYC) has had a standard deviation of 15.8%, while  Vanguard Consumer Discretionary ETF (VCR) has had a volatility of return of 19.0%. Unlike the other two funds, IYC holds nondiscretionary retailers, which as a result keeps its volatility relatively lower.

Fundamental View
U.S. consumer discretionary firms operate in varied arenas, with different competitive sets and characteristics. However, one factor common to consumer discretionary companies is that they all are sensitive to consumer spending, which in turn is affected most by consumer confidence. Consumer discretionary firms typically do best earlier in a business cycle and underperform later in a business cycle. As a result, XLY's holdings typically rally before the rest of the economy.

Retailers make up the biggest slice of XLY. The rise in e-commerce and, more recently, mobile commerce is a disruptive change for retailers. While U.S. retailers have benefited from a stronger consumer, certain retail subsectors are at risk from  Amazon.com (AMZN) (which XLY holds) and other online merchants if they do not adapt to changing consumer expectations and rapidly evolving technologies. Amazon has outstanding fulfillment capabilities and formidable pricing. The latter is critical for a consumer that generally is exhibiting more price sensitivity than prior to the Great Recession. For retailers to compete effectively with Amazon, they need to be creative with nonmobile tactics, such as price-matching efforts, other promotional activities, store-within-store partnerships with key suppliers, and online order fulfillment from local stores, as well as mobile tactics involving marketing, conversion, information purposes, and payments. Morningstar's equity analysts are impressed with retailers' early reaction to mobile commerce and apps, and their general embrace of the technological innovations and potential functionalities. At the same time, retailers remain at a disadvantage from Amazon's fulfillment infrastructure.

Home-improvement retail, which makes up 10% of XLY's assets, has some characteristics insulating it from e-commerce competition (need for salesperson help, immediacy of need, specialized nature, and diversity of product assortment). But that retail subsector is more the exception than the rule.

Foreign currency and global consumer spending aren't having a major effect on the U.S. consumer discretionary sector, as this sector is less dependent on overseas markets than the consumer staples sector is. While several of XLY's holdings--notably,  McDonald's (MCD) and  Yum Brands (YUM)--have significant foreign sales, most firms in this ETF make the vast majority of their sales in the United States. And while the strong dollar has been hurting companies with major overseas sales, McDonald's has plenty of other structural problems it has been battling anyhow. In the near to medium term, Morningstar's analysts are cautious on global consumer spending, particularly in emerging and developing markets. Over the long run, however, our analysts are relatively optimistic about consumer firms' prospects in emerging-markets economies.

Although consumer confidence recently has declined amid anemic real wage growth; elevated cost-of-living expenses such as rent, utilities, and health care; and stock market weakness, Morningstar's equity analysts have adopted a balanced outlook for spending among lower- to middle-income consumers, acknowledging positives in continued employment gains, general housing market improvements, and lower gas prices.

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 comprises about 13% 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 0.15% expense ratio is low, although there are cheaper alternatives. VCR charges slightly less, at 0.12%, and FDIS charges 0.12%. XLY's estimated holding cost of 0.19% is slightly higher than its expense ratio. Estimated holding costs are primarily composed of the expense ratio but also include transaction costs, sampling error, and share lending revenue.

Alternatives
Investors can consider VCR (0.12% expense ratio), which holds 385 companies and thus is a far more diversified way to invest in the sector. A pricier ETF with slightly different exposure is IYC (0.43% expense ratio), which, unlike XLY and VCR, holds some defensive retailers like Wal-Mart (WMT).

Fidelity MSCI Consumer Discretionary ETF (FDIS) charges a very inexpensive 0.12% but has minimal assets and is thinly traded. FDIS tracks a slightly different index from VCR--the MSCI USA IMI Consumer Discretionary Index--while VCR tracks the MSCI US Investable Market Consumer Discretionary Index. As a practical matter, the two indexes are very similar.

 First Trust Consumer Discretionary AlphaDEX ETF (FXD) (0.70%) spreads its 131 stocks more evenly; its top 10 holdings comprise 14% of assets. FXD's enhanced index takes value and growth factors into account when it draws component firms. Because FXD considers value factors, its holdings generally are a little less "growthy" than those found in XLY or VCR. Despite its stock-selection methodology, FXD's performance has lagged its larger consumer discretionary ETF peers over the past three and five years.

An international option is iShares Global Consumer Discretionary (RXI) (0.47%). However, with this fund investors essentially get an overweighting to automakers, as RXI's top 25 holdings include  Toyota (TM), Daimler,  Ford (F),  General Motors (GM), and  Honda (HMC).

The performance of all of the above-mentioned ETFs is very highly correlated. As such, VCR is the best combination of liquidity and price. Also, VCR's estimated holding cost is just 0.11%.

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Robert Goldsborough does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.