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Inside the Top Zacks Ranked Retail ETF

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The market at large is improving this year with the S&P 500 and Dow Jones reaching new highs on improving global sentiment. While financials have led the way, a number of other sectors have also performed admirably this year such in health care and energy.

The retail sector has also performed remarkably well year-to-date (read: 5 Sector ETFs Surging to Start 2013). This trend suggests a bullish run with widespread positive sentiment throughout the equity world.

The retail sector is poised to benefit from an improving economy, an increase in consumer spending and growing employment. A recovery in the auto and housing market should fuel further growth in the U.S. retail sector.

This is evident by the December sales number which grew 4.1% year over year. This is a far better than the summer low of 3.5% but still a long way from 9.2% achieved 18 months back. The recovery in sales is yet to match the earlier highs.

While some are concerned over recent tax increases and high gas prices in the U.S. market, this hasn’t really trickled down into consumer confidence yet. Furthermore, with surging home prices and an improved employment situation many could be feeling better about the economy, even with these negatives (read: Time to Buy Retail ETFs?)..

This suggests that retail could still have some room to run, and that these firms could benefit from overall positive market trends. Given this, a look at the top ranked ETFs in the space could be a good idea. One way to find a top ranked ETF in the retail space is by using the Zacks ETF Ranking system.

About the Zacks ETF Rank

This technique provides a recommendation for the ETF in the context of our outlook of the underlying industry, sector, style box or asset class. Our proprietary methodology also takes into account the risk preferences of investors as well.

The aim of our models is to select the best ETFs within each risk category. We assign each ETF one of the five ranks within each risk bucket. Thus, the Zacks Rank reflects the expected return of an ETF relative to other ETFs with a similar level of risk.

Using this strategy, we have found one ETF in the space – SPDR S&P Retail ETF (XRT) – that has a Zacks Rank #2 (Buy). We expect it to outperform its peers in the high-risk tolerance bracket when compared to other funds in the segment (see more ETFs in the Zacks ETF Center).

XRT: A Solid Choice in Retail Space

Launched in January 2006, the fund has emerged as a strong winner in the retail space, producing more than 93% return over the past three years. The product seeks to match the price and yield of the S&P Retail Select Industry Index, an equal weighted index. XRT is by far the largest and most popular fund in the retail space.

The product holds a great deal of securities, about 98, and offers wide diversification across individual holdings as no single firm makes up more than 1.7% of XRT. These securities are again well spread between growths and blend style. This ensures concentration risk of just 2.39%. Netflix (NFLX), Rite Aid (RAD) and Supervalu (SVU) are the top three holdings in the fund’s portfolio.

Though the ETF charges 35 basis points per year in fees from investors, expense ratio is considered the lowest in the category. Additionally, the fund is extremely liquid as it trades in higher volumes of more than 4 million shares per day. This suggests that investors do not have to pay an extra cost in the form of bid/ask spread at the time of trading.

The product has been able to manage assets of $754.5 million, returning more than 6% year-to-date. In fact, this return is higher than the returns from the S&P 500 fund (SPY) by roughly 140 bps. XRT also generated impressive returns of about 20.8% last year and yields a good 1.54% in annual dividends (read: 3 ETFs at the Heart of The Recent Rally).

Further, the ETF has significant correlation with the S&P 500, as indicated by R-Squared of 67.87%. It is constantly outperforming its benchmark index, as depicted by positive alpha.

XRT: A Focused Product

The fund allocates about half of the assets to small/micro cap firms, which tend to be highly volatile than the large and mid counterparts. Large and mid caps account for the remaining portion of the basket (read: Mid Cap ETFs Leading the Market in 2013).

Small cap securities tend to have less correlation with the macroeconomic trends and have less international exposure than the large cap counterparts. So, these securities rely more on the domestic economy. If the international economy performs better than the domestic economy, then small cap stocks can underperform.

From a sector perspective, specialty retail takes the top spot in the basket with 61% share, followed by departmental stores (12%), Internet and catalog retail (11%), food retail (9%), drug stores (4%) and hypermarkets (3%). This indicates its heavy reliance on a particular sector.

As a result, XRT might experience levels of volatility, making it a high risk tolerance product.

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