Commentary

Retailing is a notoriously competitive industry characterized by low barriers to entry and essentially nonexistent customer-switching costs. For instance, fashion apparel retailers like Wet Seal tend to rely on trend-spotting to make key merchandising decisions during a handful of crucial seasons, like back-to-school and the holidays. Buffeted by bruising competition and fickle consumer tastes, retailers typically struggle to trench out durable competitive advantages, with only the largest ( Wal-Mart, Home Depot) or best entrenched ( Amazon) achieving dominance.

In our view, the U.S. consumer and the financials sector are theoretically in the same position in terms of the deleveraging process that must take place. While the unwinding of leverage at banks threatens lower returns on equity for those businesses, the unwinding of the consumers' debt-laden balance sheet could result in a period of contracting consumer spending. While energy and food price inflation, which previously choked consumers' disposable income budgets, has retreated from recent highs, we still see a number of challenges ahead. The U.S. consumer appears tapped out thanks to lower asset prices (namely, housing and stocks), weak labor markets, stricter access to credit, and debt deleveraging.

Despite these headwinds, investors seeking exposure to discretionary consumer spending--retailing stocks in particular--might consider PowerShares Dynamic Retail as a suitable satellite holding.

PowerShares Dynamic Retail is a cyclical play that is highly correlated, and dependent on consumer spending. While the fund will invest in some defensive retailers such as Wal-Mart and Walgreen that should continue to benefit from consumers' newfound value-consciousness, the overwhelming majority of the index can be categorized as discretionary. Needless to say, this is not a fund you would want to own in a period when the economy is potentially facing a prolonged recessionary environment. That said, it could be worth keeping an eye on this fund, as these cyclical firms usually rally before the economy fully emerges from its slump. After all, the market is a forward-looking discounting mechanism.

This portfolio differs from its rivals in the broad way it defines retail. For example, while it holds traditional brick-and-mortar retailers such as TJX Companies and Gap, the fund also includes online merchants like Netflix and Amazon. The portfolio has also routinely included rental and leasing companies such as Rent-A-Center and Aaron's, names not typically found in rival funds. Worth noting is that PMR excludes many of the media firms (such as Walt Disney and Time Warner) that are so prevalent in broader consumer-services and consumer discretionary ETFs.

As this is a quantitative-active fund that tracks a dynamic Intellidex benchmark, investors should expect significantly higher portfolio turnover relative to traditional ETFs that track traditional broad market indexes. However, this shouldn't deter investors, because the unique "in-kind" creation and redemption process for ETFs helps ensure maximum tax efficiency. Because of the dynamic nature of the ETF, investors may wish to scan the portfolio holdings on a quarterly basis to ensure that the portfolio continues to meet their investment objectives or expectations. We'd also note that the ETF's screening and weighting methodology leads to a portfolio that's biased toward small- and mid-cap stocks. For instance, PMR's average holdings-weighted market cap at the end of August 2009 was about $3.5 billion, compared with approximately $4 billion for the equal-weighted SPDR S&P Retail and roughly $18 billion for the cap-weighted Consumer Discretionary Select Sector SPDR.

By our estimates, approximately 85% of this ETF's underlying index could be categorized as discretionary. Categories we deem to be discretionary and thus more sensitive to the economic environment include: apparel retailers (ranging from American Eagle to Men's Wearhouse), department stores (like Macy's and Kohl's), and specialty retailers (like Cabela's and Hot Topic). The remaining 15% of the index falls under the nondiscretionary umbrella. This includes discount retailers (like Wal-Mart and Family Dollar Stores), grocers (like Kroger and Safeway), and automotive parts retailers (like AutoZone and Advance Auto Parts). Remember, though, that as a result of the fund's unique weighting methodology, many smaller and less established names can have similar weightings as the industry behemoths.

After posting a 25% rally year to date through Sept. 28, 2009, and bouncing more than 50% off of its March low, investors must consider how much of the anticipated recovery has already been discounted. Still, intrepid investors may look to this ETF as an "early recovery" that could still have some legs. In any case, this fund should be treated as a small satellite holding by investors looking to bulk up their exposure to the consumer. As with any investment decision, before pulling the trigger, we'd urge investors to consider the macroeconomic climate. With about two thirds of economic activity fueled by consumer spending, it is prudent to examine the economic backdrop before making a bet on the health of the U.S. consumer. While this is not an endorsement for market-timing practices, we think investors should first weigh the facts against what the market is presumably already pricing into consumer discretionary-related stocks.

Given the fragile state of the domestic economy and the portfolio's leverage to a common risk factor--the vitality of the U.S. consumer--we'd need a healthy margin of safety to invest here. In short, it is difficult to draw much hope for a rebound in consumer spending in the near term, in light of still-weak housing prices, declines in employment, and dismal readings from consumer confidence surveys.

Fees
This ETF levies a 0.60% expense ratio, which is inexpensive compared with the typical mutual fund, but costly compared with other retailer ETFs. For instance, SPDR S&P Retail can be had for 0.35% per annum. Considering PMR's relative outperformance, we think its expenses are reasonable. Whereas most ETFs track static indexes that require minimal intellectual input and maintenance, this fund rebalances regularly based on cumulative scores from its proprietary Retail Intellidex model.

Alternatives
SPDR S&P Retail is the closest alternative to PMR, in terms of industry exposure. Moreover, because of its equal-weighting methodology, XRT courts a similar size (average market capitalization) profile as PMR. Over the past three years, these two retail-focused ETFs have displayed 88% correlation, despite having less than 20% overlap between the two portfolios.

Investors can gain exposure to the retail industry through owning Retail HOLDRs. However, because RTH is a static, market-cap-weighted portfolio, it is extremely concentrated. For example, RTH's top 10 holdings soak up more than 82% of the index, with Wal-Mart, Home Depot, and Target comprising about 43% of total assets. RTH's average market cap, on a holdings-weighted basis, is more than $39 billion--nearly 10 times that of PMR and XRT.

For broader exposure to discretionary consumer spending, investors could also consider Consumer Discretionary Select Sector SPDR (0.21% expense ratio), Vanguard Consumer Discretionary (0.25% expense ratio), or iShares Dow Jones U.S. Consumer Services (0.48% expense ratio).