‘Tis the season to find the perfect ETF for that special someone, you or your client.

It’s hard to believe, but the holiday season is right around the corner. If it’s true, as the retail industry’s trade group predicts, that the holiday sales will jump compared with last year, it’s time for investors to profit with ETFs that hit the right note.

The National Retail Federation predicts that holiday sales are expected to increase 2.3 percent over last year to $447.1 billion. That’s below the 10-year average of 2.5 percent growth, but a heck of a lot better than last year’s paltry 0.4 percent rise.

Overall retail stocks have been able to outperform the major indexes in 2010 and, if the numbers for the holiday season come in better than expected, the rally could continue. The S&P Retail Index is up 14 percent year-to-date and, because there’s so much diversity in the sector, ETFs are worth looking at.

Investing In Retail

For example, an investor could invest in a dollar store or a high-end jewelry retailer. The demographic of the customer for each store is dramatically different and each retailer will flourish during varying economic times.

Again, a great way to eliminate the risk associated with attempting to not only pick the correct subsector, but also the best stock within that subsector is to turn to ETFs. And even among the three ‘retail’ ETFs there’s diversity that’s worth understanding.

The SPDR S&P Retail ETF (NYSEArca: XRT) is composed of a basket of 68 stocks that are involved in areas such as apparel retail and automotive retail. It’s very diversified, with the largest holding, Gymboree Corp (NYSEArca: GYMB) making up only 2.3 percent of the allocation.

The diversity lowers the risk of XRT because if one subsector, such as car dealers, struggles, it won’t have a major impact on the performance of the ETF because auto dealers only makes up 11 percent of the entire allocation. XRT’s largest subsector is the apparel retail, which makes up 32 percent, and specialty stores comprise 17 percent. The ETF has a gross expense ratio of 0.35 percent and the current dividend yield is 1.3 percent. Year-to-date the ETF has risen about 22 percent.

The HOLDRS Retail ETF (NYSEArca: RTH) sounds as if it would be similar to XRT, but that’s far from true. RTH is composed of only 18 stocks and the top three holdings make up 44 percent of the allocation. Because of its heavy reliance on three stocks, the ETF has lagged its peers this year, up only 7 percent in 2010.

One major factor holding RTH back has been its largest holding, Wal-Mart (NYSEArca: WMT), which has been underperforming all year. As far as annual expenses, HOLDRS charges $2 for each round lot of 100 shares. With RTH trading near $100 a share, the expense ratio amounts to only a few basis points.

Not as popular as the first two retail ETFs is the PowerShares Dynamic Retail ETF (NYSEArca: PMR). The composition of PMR is attractive, with the largest holding only accounting for 5 percent of the allocation and a total of 30 stocks. The performance for the year falls in the middle of the other two, with a gain of 12 percent and a dividend yield of 0.86 percent. The expense ratio is 0.60 percent, a little on the high end for the sector.

Making the Right Choice

Clearly investors have to make an important decision when investing in retail ETFs due to their differences. I will immediately rule out RTH due to its heavy concentration on the top three stocks. If I wanted to have that much exposure to Wal-Mart, I’d simply buy the stock.

Choosing between XRT and PMR comes down to two factors. First the expense ratio of XRT is considerably lower than PMR. Second, and more important, is the diversity that XRT gives an investor. When buying XRT, there’s instant exposure to all subsectors within retail without the company-specific risk. After all, this is the beauty of ETFs – low cost and instant diversification.

Matthew D. McCall is editor of The ETF Bulletin and president of Penn Financial Group LLC, a Ridgewood, N.J.-based wealth management firm specializing in investment strategies using ETFs.