The risk of investing in this sector is that it’s very cyclical and usually goes hand-in-hand with the health of our economy. Bad economic news, high unemployment, falling home prices and a high savings rate can have a negative impact on discretionary spending.

Investing in this area depends on how optimistic, or pessimistic, the U.S. consumer is, and the long-term effects of the recent credit crunch are a big unknown factor. But, as an economy improves, consumer spending increases and the discretionary companies would produce short-term gains, which would outweigh the consumer staples sub-sector.

Some of the best-performing consumer discretionary ETFs in the last year have been First Trust Consumer Discretionary AlphaDEX (NYSEArca: FXD), PowerShares Dynamic Consumer Discretionary (NYSEArca: PEZ) and Vanguard Consumer Discretionary (NYSEArca: VCR).

Consumer Staples

Within the world of retail, consumer staples are considered a safe-haven and better able to withstand economic downturns. Part of the consumer staples’ relative reliability is easily explained: staples are the “necessary” items that few of us can live without. This includes toothpaste, household cleaners, toilet paper and basic food items.

The demand for staples does not change much, even if their prices go up, since there are no substitutes for the products themselves. Still, consumers may choose to shop around for the lowest prices among suppliers, which don’t allow companies to raise prices too much, but suppliers may reduce their costs.

The cost of making consumer staple products lies in commodities. Additional factors that determine growth of staples include price and the differentiation between products. Needless to say, competition between prices usually results in consumers picking the low-cost product when comparing two similar products. However, companies may increase demand for their own products by differentiating their products as a superior product through advertising, which would help the company to control the price.

Top-performing consumer staples ETFs over the last year include First Trust Consumer Staples AlphaDEX (NYSEArca: FXG), Rydex S&P Equal Weight Consumer Staples (NYSEArca: RHS) and Consumer Staples Select Sector SPDR (NYSEArca: XLP).

Choosing Retail ETFs

If you’re looking for a retail ETF allocation for your clients, be sure to look under the hood of the funds you’re considering. Although consumer discretionary and consumer staples are two distinct sub-sectors of retail investing, many companies have their hands in both worlds and make an appearance in both types of ETFs. You can use the ETF Resume to ensure that you’re not overly exposed to any one company.

It’s wise to watch the mood of the markets when it comes to retail ETFs, since this sector is highly sensitive to the state of the economy. You can add consumer ETFs to your ETF Watchlist and set up alerts to be notified of trading opportunities in this sector.

Read the disclaimer; Tom Lydon is a board member of Rydex|SGI.