3 Sector ETFs Braving the Market Slump

Zacks

Much to the surprise of many analysts, interest rates in the U.S. have seen a downward motion in 2014 with the 10-year Treasury yield tumbling 13 basis points to 2.61% over the past one month.

While many believed that the escalation of the Fed QE taper will result in rising rates, the market proved exactly the opposite, as risk-adverse investors flocked to safe-haven U.S. government debt.

The escape to safety came in the wake of massive sell-offs in U.S. stocks. An emerging market lull, a weak U.S. job scene and manufacturing data as well as the slowdown in the world’s second largest economy-- China – all led the S&P 500 index to witness the worst decline in almost two years.

Moreover, we believe that over-valuation, profit booking activities and sub-par guidance from companies are causing corrections in the markets (read: Survive the Slump with These Inverse Equity ETFs).

While the overall stock market is going through a rough phase currently, as evident by roughly 5% loss incurred by the SPDR S&P 500 ETF (SPY) in the year-to-date frame, there are a few segments which have stayed in the green. This is especially true in the rate-sensitive sectors, as these have been the clear winners in this falling rate environment.  

Below are three ETFs surviving the broader market slump, and are likely to benefit if the interest rates stay subdued in the near term:

Utilities - Utilities Select Sector SPDR ETF (XLU) 

Being a high yield and safe sector, utilities started the year on a strong footing. The sector satisfies both the criteria investors are currently looking for. One of these is yield (as yields out of U.S. treasury bonds are sinking now) and the other is a safer option for investment.
          
Operating environment is also in favor of the utility sector.  As the utility sector requires huge infrastructure which places a massive debt burden and the resultant interest obligation on these companies, the companies tend to outperform when rates are low in the economy. 

Secondly, barring some occasional downbeat data, the overall growth of the U.S. economy remains pretty assuring. And higher infrastructural investment is warranted in a growing economy (read: A Comprehensive Guide to Utility ETFs).

The sector is not meant for those who expect huge market-beating returns. It is among the most stable sectors for a long haul and the companies in this space are likely to be decent investments.

XLU is a big winner in this space and by far the most popular choice in the utilities space. The fund tracks the S&P Utilities Select Sector Index. The product has roughly $5.07 billion in AUM and trades about 10,500,000 in volume a day, while its cost is just 16 basis points a year.  

Holding 32 securities in its basket, the product is largely concentrated in the top 10 holdings with less than 60% of share. Its top three holdings account for one-fourth of the portfolio. 

In terms of performance, the product generated about 13% last year and has returned nearly 3.7% year to date. XLU gives about 3.75% in yield.

MLPs – JPMorgan Alerian MLP Index ETN (AMJ)

Energy MLP ETFs – another rate sensitive zone of the investment world – avoided the rising rate concerns in 2013 pretty well and rewarded investors with a 16% gain. This corner of the market seems poised to continue a decent streak this year as well thanks mainly to consistent growth in the energy industry with new developments in the field of unconventional energy. The recent slide in interest rates has been a boon to the industry.

Investors should also note that MLPs do not pay taxes at the entity level and are thus able to pay out most of their income in the form of dividends. This feature also helped the segment to outperform the boarder market in the current low-yield scenario (read: Direxion Rolls Out High Income MLP ETF).

While a major part of the space has benefited so far this year, we are here to discuss one the biggest products by assets in the space – AMJ.

AMJ – which tracks the Alerian MLP Index – invests about $5.85 billion of assets in 50 holdings. The product charges investors a slightly higher expense ratio of 85 bps per year.

Its yield stands at 4.70% as of February 3, 2014. AMJ returned about 9.6% in 2013 while it has gained 1.05% so far this year.

Mortgage REITs - iShares FTSE NAREIT Mortgage Plus Capped Index Fund (REM)

Thanks to declining mortgage rates, mortgage REITs have been on an uphill ride since the start of the year and could be due for some more gains if volatility and fears over stock markets persist and investors flee toward bonds.

30-year and 20-year mortgage rates dropped to 3.55% and 3.29%, respectively. Short-term rates are falling faster than the long-term rates thereby leading to a wide spread and boost higher profits for mREIT companies (read: Mortgage REIT ETFs in Focus on Renewed Taper Concerns).

There are three mortgage REIT ETFs currently. Though the trio has seen at least 4% gain thus far in 2014, and REM has led is leading the pack.  REM tracks the FTSE NAREIT All Mortgage Capped Index and invests its $1 billion in assets in its 36 stock portfolio.

The fund has considerable company-specific risks with more than 60% of assets invested in the top-10 holdings. REM charges 48 bps in annual fees which is higher than the other two options – MORL and MORT.

However, yield-starved investors should note that REM yields 15.2% annually (as of February 3, 2014). Though REM lost 2.47% in 2013, it has gained more nearly 5.0% so far this year.



Bottom Line

As one can see in the above chart, SPY, targeting the S&P 500 index, has seen weakness as of late, while XLU, AMJ, REM added 1.97%, 1.27% and 1.00%, respectively, flouting the stock market’s common sentiment.

We believe that this trend will hold up in the coming days at least until the S&P 500 index reaches a compelling valuation. And even if the interest rates start to edge up after that, overall economic growth and demand for energy will be there to back up utilities and MLP funds, though things might not be smooth for mREITs.

Either way though, if rates stay subdued, any of these funds look to be interesting plays for investors in the coming months, and they could definitely continue to match or outperform the S&P 500 too.  

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Read the analyst report on AMJ

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Read the analyst report on XLU


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