ETF Tactics for a Rate-Proof Portfolio

With back-to-back months of solid jobs growth and moderate inflation, the era of tightened policy might kick in as early as in two weeks, as the chance of the first rate hike in almost a decade now looks more real. The Fed is slated to increase interest rates at its upcoming December 15–16 policy meeting, but at a gradual pace (read: Surprise ETF Winners Post Job Data).

The initial phase of increase will actually be good for stocks as it will reflect an improving economy and a lower risk of deflation. Plus, higher rates would attract more capital to the country, thereby boosting the U.S. dollar against the basket of other currencies. However, since a strong dollar should have a huge impact on commodity-linked investments, a rising rate environment will also hurt a number of segments.

In particular, high dividend paying sectors such as utilities and real estate would be the worst hit given their higher sensitivity to rising interest rates. Further, securities in capital-intensive sectors like telecom would also be impacted by higher rates. In such a backdrop, investors should be well prepared to protect themselves from higher rates.

Here are number of ways to create a rate proof portfolio that could prove extremely beneficial for ETF investors in a rising rate environment (read: Before the Fed Rate Hike, Buy These Stocks and ETFs):
 
Bet on Rate Friendly Sectors

A rising rate environment is highly beneficial for cyclical sectors like financial, technology, industrials, and consumer discretionary. Investors seeking protection against rising rates could load up stocks in these sectors through diversified or niche ETFs. Some of the broad ETFs having double-digit exposure to these four sectors are iShares Core S&P Total U.S. Stock Market ETF (ITOT), Schwab U.S. Broad Market ETF (SCHB), and iShares Russell 3000 ETF (IWV). Other sectors make up for a smaller part of the portfolio of these funds.
 
Investors seeking a concentrated exposure to the particular sector could find iShares U.S. Financial Services ETF (IYG), Select Sector SPDR Technology ETF (XLK), First Trust Industrials/Producer Durables AlphaDEX Fund (FXR) and Consumer Discretionary Select Sector SPDR Fund (XLY) intriguing. All these funds have a Zacks ETF Rank of 2 or ‘Buy’ rating, suggesting their outperformance in the coming months.

Focus on ex-Rate Sensitive ETF

The timing of interest rates hike is resulting in higher market volatility. For protection against both, PowerShares S&P 500 ex-Rate Sensitive Low Volatility Portfolio (XRLV) could be an ideal bet. This fund provides exposure to 100 stocks of the S&P 500 that have both low volatility and low interest rate risk. This approach looks to exclude the stocks that tend to underperform in a rising interest rate environment, and is tilted toward financials (28.1%), industrials (21.5%) and consumer staples (15.2%). As such, XRLV is a compelling choice to play the rising rate trend.

Follow Niche Bond ETF Strategies

Though the fixed income world will be the worst hit by rising rates, a number of ETFs like iShares Floating Rate Note ETF (FLOT) and iPath US Treasury Steepener ETN (STPP) that employ some niche strategies could see huge gains (read: How These 4 ETFs Will Benefit from a Rate Hike).

This is because a floating rate note ETF pays variable coupon rates that are often tied to an underlying index (such as LIBOR) plus a variable spread depending on the credit risk of the issuers. Since the coupons of these bonds are adjusted periodically, they are less sensitive to an increase in rates compared to traditional bonds. On the other hand, the Steepener ETN directly capitalizes on rising interest rates and performs better when the yield curve is rising. The ETN looks to follow the Barclays US Treasury 2Y/10Y Yield Curve Index, which delivers returns from the steepening of the yield curve through a notional rolling investment in the U.S. Treasury note futures contracts.

Shorten Bond Duration

Higher rates have been cruel to bond investors, especially the longer term ones, as an increase in rates has always led to rising yields and lower bond prices. This is because price and yields are inversely related to each other and might lead to huge losses for investors who do not hold bonds until maturity. As a result, short-duration bond are less vulnerable and a better hedge to rising rates (read: Rate Hike in the Cards: How Will Bond ETFs React?).
 
While there are several options in this space, SPDR Barclays 1-3 Month T-Bill ETF (BIL), iShares Short Maturity Bond ETF (NEAR) and Guggenheim Enhanced Short Duration ETF (GSY) with durations of 0.16, 0.36 and 0.17 years, respectively, seem intriguing choices.

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SCHWAB-US BR MK (SCHB): ETF Research Reports
 
ISHARS-1500 IDX (ITOT): ETF Research Reports
 
ISHARS-RS 3K (IWV): ETF Research Reports
 
SPDR-TECH SELS (XLK): ETF Research Reports
 
ISHARS-US FN SV (IYG): ETF Research Reports
 
FT-INDL/PROD (FXR): ETF Research Reports
 
SPDR-CONS DISCR (XLY): ETF Research Reports
 
PWRSH-SP5 XRATE (XRLV): ETF Research Reports
 
ISHARS-FL RT BD (FLOT): ETF Research Reports
 
IPATH-UST STEEP (STPP): ETF Research Reports
 
ISHRS-ST MT BD (NEAR): ETF Research Reports
 
SPDR-BC 1-3M T (BIL): ETF Research Reports
 
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