Featured Article: A Comparison of Consumer Discretionary ETFs

Consumer discretionary exchange-traded funds (ETFs) offer investors low-cost exposure to companies such as luxury goods retailers, fast food restaurants, and home improvement stores that rely on optional consumer spending. The consumer discretionary sector has a history of outperforming the market during the early stages of business cycles. It underperforms as the cycle matures and during recessions. In December 2016, the University of Michigan consumer sentiment survey reached its highest level in 10 years due to postelection optimism. Recent labor and unemployment reports reflect a strong job market, which also contributes to consumer confidence and additional spending. The five-star Morningstar-rated iShares U.S. Consumer Services ETF (IYC) and the four-star-rated Consumer Discretionary Select Sectors SPDR (XLY) and Vanguard Consumer Discretionary (VCR) ETFs are three reasonable options for investors seeking consumer discretionary sector exposure.

Fund Investment Strategies

With $812 million in assets under management (AUM), IYC is the smallest of the three funds. It uses a market capitalization–weighted exposure to domestically domiciled companies that primarily depend on discretionary consumer spending. The fund seeks to track the highly diverse Dow Jones U.S. Consumer Services Index, which contains 185 individual names. Managers will invest 90 percent of assets in securities and depository receipts representing the stocks contained within the underlying benchmark. With a 77 percent exposure, the index is weighted toward giant- and large-cap high-quality names. There is also an 18.3 percent exposure to mid-cap shares.

Following a full replication strategy, XLY attempts to track the 13 percent of companies that compose the consumer discretionary sector of the broader S&P 500 Index. Individual stocks are included in the portfolio based on the assignment rules for the S&P 500 and are added or removed from the ETF when the index is reconstituted. With slightly more than $12 billion in AUM, XLY is the largest of the funds. It is heavily weighted toward quality names.

The passively managed VCR also uses a full replication strategy as it seeks to track the returns of the benchmark MSCI US Investable Market Consumer Discretionary Index, an index composed of variably sized U.S. companies. Fund managers invest substantially all AUM in stocks contained within the index. The $2.1 billion fund holds stocks in the same weighting as the underlying benchmark.

Fund Similarities and Differences

IYC has a 98.77 percent exposure to domestic shares and a 1.1 percent allocation to stocks in Developed Europe. Its cash position is negligible. IYC is underweight consumer cyclical shares and slightly overweight the industrial, consumer defensive and healthcare sectors when compared with its benchmark. The fund has a price/earnings (P/E) ratio of 20.31 and a price-to-book of 3.95.

XLY has a greater than 99 percent exposure to domestic stocks. Fund managers hold consumer cyclical, communications services, and consumer defensive shares in the same weighting as its benchmark. In addition to a price-to-book of 4.21, XLY has a 19.3 P/E ratio.

With more than 97 percent of AUM allocated to domestic shares, VCR holds a small 1.5 percent exposure to international stocks domiciled in Greater Europe. The remainder is held in cash. The fund holds consumer cyclical, communication services, and consumer defensive stocks in the same weighting as its benchmark. VCR has a P/E ratio of 18.82 and a price-to-book of 4.3.

All three funds’ holdings overlap significantly. XLY shares 71 percent of its holdings with IYC. While IYC concentrates 44 percent of AUM in its top 10 holdings, VCR has a 42 percent concentration. XLY allocates 54 percent of its assets to largest 10 positions. The top 10 common holdings in all three funds include Amazon (AMZN), Comcast (CMCSA), Home Depot (HD), Walt Disney (DIS), McDonald’s (MCD), Starbucks (SBUX), and Priceline (PCLN). While IYC invests in Wal-Mart (WMT), CVS (CVS), and Costco (COST), XLY has Nike (NIKE), Time Warner (TWX), and Charter Communications (CHTR). VCR also holds Nike and Time Warner, as well as Lowes (LOW). While media firms constitute 26 percent of XLY and 23.7 percent of IYC, they are only 14 percent of VCR.

Although most of the funds’ holdings are U.S.-based, many have significant overseas operations, which increases exposure to lingering macroeconomic factors in Europe and China. With approximately 200 more individual holdings than IYC, VCR’s extra holdings represent only 5.1 percent of AUM.

Historical Performances, Risks, and Fees

XLY has the high Morningstar return rating, while IYC and VCR ETFs garner above-average ratings. XLY has the highest 12-month yield at 1.64 percent, followed by VCR’s 1.54 percent and IYC’s 1.06 percent.

XLY has an average risk rating, a three-year beta of 1.01, and a 12.62 standard deviation. VCR also has an average risk rating and features a 1.01 beta and a 12.56 standard deviation. Earning a below-average risk rating, IYC has a 0.93 beta and an 11.76 standard deviation over the same period. The category three-year beta and standard deviation averages are 0.95 and 13.3, respectively. IYC keeps volatility lower by holding some nondiscretionary retailers within its portfolio.

With a 0.44 percent expense ratio, IYC charges substantially more than many of its competitors. It has also lagged its benchmark by 48 basis points since its June 2000 inception. In comparison, VCR has a 0.1 percent expense ratio, the second lowest of any large consumer discretionary ETF. This ETF trailed its benchmark by just eight basis points in 2016. Lagging its benchmark by 18 basis points, XLY charges a slightly higher 0.14 percent expense ratio.

Suitability and Recommendations

The consumer discretionary sector is generally more volatile than the broader market. Because of their narrow focus, greater volatility, and high sector concentration, these ETFs are a suitable satellite holding of a well-diversified portfolio when employment rates, income, and consumer confidence are on the rise.

Although these three funds are very similar, they do differentiate themselves. IYC has the lowest correlation and lowest volatility of the three, and it did hold up best during the financial collapse of 2008. However, it also offers the lowest yield and has the highest expense ratio. The high cost can drag on returns over the long term.

VCR has the broadest portfolio, lowest expenses, and lowest tracking error, and a solid yield. VCR historically performs best during the most bullish of years, when its small- and mid-cap exposures deliver an upside kick. An investor confident in the consumer discretionary sector as well as the overall stock market should gravitate toward VCR.

As the lowest-cost fund, XLY has the highest yield and heavy large-cap exposure. Even after adjusting for assets and share price, XLY’s trading volume is about 10 times that of VCR, as the latter attracts long-term buy-and-hold investors.

We have currently issued Buy recommendations for XLY and IYC, with rankings of 90 and 88, respectively. Both are solid alternatives. Given the positive outlook for the remainder of 2017, our choice is VCR, which we have upgraded to a Strong Buy recommendation with a ranking of 93. This fund should outperform its competitors on a relative basis, while charging a lower fee.