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The economy seems to be in recovery. Housing starts are at a five-year high, employment numbers are coming in positive, Americans have deleveraged significantly from the credit bubble of the 2000s and generational low mortgage rates have certainly helped improve U.S. consumer balance sheets.

Moving your portfolio to position for a change in consumer sentiment and consumption could lead to big profits. We'll look at a few of the bigger retail ETFs, and discuss some methodologies that may be more successful than others in finding the best retail stocks.

Is America Ready to Spend?

American consumers face some of the best financials in recent history. Thanks to low interest rate policy, debt is more affordable than ever before. Americans spend just 10.61% of income to service existing debts, which is down from a peak of over 14% in the third quarter of 2007.

Here's a chart of the debt service ratio since 1980:

(click to enlarge)

Ten percent seems to be the "floor" at which Americans feel comfortable expanding their own balance sheets once again.

Americans are also signaling a desire to make major purchases. In a recent consumer confidence poll, the number of Americans indicating they wanted to purchase a home hit an all time high of 6.9%, the highest since 1960. Seeing as home sales are a major driver of employment, and financial leverage, a faster home sales pace could also bring bigger consumer spending on ancillary products - furniture, home improvements, appliances, etc.

Sorting for Retail Winners

How an exchange-traded fund makes a stock selection is just as important as what it selects. It's safe to say that much of the retail landscape is changing. Offline retailers are losing business to online retailers while category killers like Best Buy (BBY) may soon go the way of other category killers like Circuit City or Borders. It's all too easy to "showroom shop" with your Red Laser App in stores while purchasing on the likes of Amazon (AMZN) while the explosion of discount gift cards (whereby virtually anyone can save 7-12% on their purchases) may help retain some consumer loyalty in the big box stores.

Knowing that part of this industry is in a secular and likely permanent decline, it would be wise for investors to track market cap weighted indexes. Equal weighted indexes of pure retailers will keep lagging stocks in a high proportion of the ETF while failing to allocate more money to new retail leaders.

The types of retailers the funds hold are also important. Grocery retailers are certain to grow in an economic recovery, but not to the extent of retailers that sell consumer discretionary products. Wal-Mart, for example, simply won't grow as fast as a CVS (CVS) or Target (TGT), which sell less food and more consumer products.

Some Retail ETFs that Make the Cut

Investors have two different "flavors" for consumer spending exposure:

  • Market Vectors Retail ETF (RTH) - This fund fits both key qualities in that it holds retail stocks by market cap and holds only the largest stocks, which means faltering retail companies that are falling out of style will quickly fall off the radar of this ETF. In fact, this fund boasts one of the best one-year returns of 21.56%, and an average market cap of just under $38 billion, placing investors in the largest 25 retail stocks including Wal-Mart (WMT), Amazon.com (AMZN), and Home Depot (HD). The fund is split 45-45-10 in consumer defensive, consumer cyclical, and healthcare names, making this a less volatile and risky way to play consumer spending growth.

  • SPDR S&P Retail ETF (XRT) - This fund is an equal-weighted index holding 97 different retail stocks. From the list of holdings, one can see this fund offers very different exposure that does not necessarily blend with commonly accepted ideas of consumer retail. Top holdings (the fund is rebalanced every quarter) include stocks like Shutterfly (SFLY), CarMax (KMX), and Netflix (NFLX), stocks which are better categorized as consumer discretionary or cyclical than retail companies. This fund has a 73-22-4 split consumer cyclical, consumer defensive, and technology stocks, making it a much more volatile way to play retail. Additionally, equal-weighting means that little more than 1% of the fund will be permanently invested in laggards like Best Buy (BBY) or SuperValu (SVU), which may drag on performance with each rebalance.

The bottom line: growing consumer spending should lift retail stocks. For investors seeking safer pure-play exposure, the Market Vectors Retail ETF (RTH) offers easy exposure to the largest retail players. Those who want a broader play on consumer spending with retail and consumer discretionary positions would prefer the SPDR S&P Retail ETF (XRT). Unlike other entirely cyclical sectors like homebuilding or durable goods, the retail industry has downside protection in case the recovery thesis does not completely play through.

Disclosure: ETFBase has no position in any ETFs mentioned here but is long AMZN.

Source: Bank On The American Consumer With These 2 Retail ETFs