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  • Home>Research & Insights>Investment Insights>Low-Cost Exposure to the Consumer Discretionary Sector

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    Low-Cost Exposure to the Consumer Discretionary Sector

    Its narrow focus and sector concentration make this ETF best-suited for use as a tactical tool to complement a diversified portfolio.

    Ben Johnson, 02/03/2017

    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.

    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 buying behavior, which tends to be tied to employment rates, consumer confidence, and income.

    The Select Sector SPDR ETFs tend to have high-quality portfolios as 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 18.3% compared with the S&P 500's 15.3%. 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 16.3%, while the broadest and most diversified fund, Vanguard Consumer Discretionary ETF VCR, had a volatility of return of 19.3%. Unlike the other two funds, IYC holds nondiscretionary retailers, which as a result keeps its volatility relatively lower.

    Fundamental View
    The University of Michigan's consumer sentiment index registered its highest reading in 10 years in December 2016, owing to a post-election surge in optimism. A strong job market has also contributed to consumer confidence.

    The shift to online shopping is accelerating. 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 26% of XLY. However, very little of XLY's media stake is invested in publishing and TV companies. 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 TWX. 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.

    Ben Johnson is Morningstar’s Director of European ETF Research.