(12/30/11) 2 Holiday Shopping ETFs

Everyone has been abuzz about consumer spending since the Black Friday numbers came in, so if you want to get in on the bandwagon, here are two funds worth your attention—though I'm a bit more cautious, says Ben Shepherd of Global ETF Profits.

I hope you all had an enjoyable quality time with your family and friends and have the opportunity to relax as the New Year gathers steam.

Retailers are also hoping for a happy holiday.

The National Retail Federation is certainly feeling cheerier. Over Thanksgiving weekend, shoppers spent a record $52.4 billion, as retailers offered deep discounts and longer operating hours.

Because of better-than-expected spending over Thanksgiving, the retail industry’s trade group this month boosted its forecast for holiday sales growth to 3.8% from 2.8%. That growth is well in excess of ten-year average sales growth of 2.6% and pushes total holiday spending to a record $469 billion. Higher sales have also increased port traffic by 0.3% in December.

That growth rate is significantly slower than last year’s 5.2% jump in spending. But if the forecast holds true, retailers will breathe a sigh of relief—retailers largely depend on fourth-quarter consumer spending to meet their revenue targets. The fourth quarter is make-or-break time for retailers.

But retailers are paying for this growth; the average gross margin for S&P 500 retailers fell by almost 1 percentage point to 32.2% in the third quarter, largely due to steep discounts.

A lower unemployment rate and an improved economic outlook are certainly helping holiday sales. But a sizable bump in spending isn’t a sure thing. Income growth remains stagnant, and foot traffic in shopping malls is off by more than 2% compared to last year. Online retailers such as Amazon.com (AMZN) are also pressuring brick-and-mortar retailers with free shipping and deep discounts.

SPDR S&P Retail ETF (XRT) is a passive retail exchange traded fund that tracks a basket of 96 retail stocks trading on the NYSE, AMEX, or Nasdaq exchanges. The fund uses a modified equal-weighted index that deemphasizes large-cap companies—which account for just 12.7% of assets.

The ETF also has large allocations to mid-cap and small-cap retailers, which account for about two-thirds of assets. Only 11.9% of assets are allocated to the fund’s Top Ten holdings.

The fund’s portfolio is well diversified across various subsectors of the retail space. Although the ETF has a heavy allocation to apparel retailers (about 30% of assets), it has healthy allocations to grocery stores, automotive outfits, and electronics retailers. It also allocated about 5% of assets to online retailers.

The fund is the largest retail-focused ETF, with more than $641 million in assets and almost 100 individual holdings. It is also the cheapest retail-focused ETF, with an expense ratio of 0.35%.

PowerShares Dynamic Retail Portfolio (PMR) employs a quantitative strategy that factors in growth, valuation, and risk-based metrics in the construction of its portfolio. The fund’s portfolio is concentrated, with 29 holdings, and almost half of the ETF’s assets are held in the fund’s Top Ten positions.

However, PowerShares Dynamic Retail Portfolio is more balanced in terms of market capitalization, with 40.3% of assets allocated to large caps, almost 20% in mid-cap stocks, and 32.6% of assets held in small-cap names.

PowerShares Dynamic Retail Portfolio is much smaller than SPDR S&P Retail ETF, with just $29.6 million in assets. It’s also more expensive, with an annual expense ratio of 0.63%.

Investors seeking to invest in retailers on would be better off with SPDR S&P Retail ETF. Although I don’t expect stellar retail sales this season, they should surprise to the upside. When retailers perform better than expected, SPDR S&P Retail ETF tends to outperform PowerShares Dynamic Retail Portfolio because the latter places a greater emphasis on controlling downside risk.

Nevertheless, I would approach the sector with caution.

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