With the Federal Reserve signaling interest rate hike sooner and faster than expected, investors have started looking for some profitable avenues in the rising interest rate environment (read: 3 Top Ranked ETFs from Hottest Sectors).
Fed’s Latest Comments
In the latest FOMC meeting, the Fed stated that it would continue tapering and made another $10 billion reduction in the bond-buying stimulus to $55 billion. The Fed chairperson –Janet Yellen – also said that the timing of increase in interest rates would no longer depend on the unemployment rate threshold of 6.5%, but instead be a combination of employment and inflation indicators.
Interest rate could remain low for “a considerable time”, about six months after shuttering the monthly bond purchases, which most analysts expect by the year-end. As such, short-term interest rates are expected to move up by the middle of 2015.
This change in the timing of possible interest rate hike roiled the global stock and bond markets, resulting in higher yields. However, the financials sector, especially banks and insurance, are seeing strong inflows and is the main beneficiary of a rising interest rates environment (see: all the Financial ETFs here).
ETFs to Consider
Investors could definitely tap this space by investing in the following ETFs and could avoid the single stock risk as well.
A rising interest rate scenario would be highly profitable for the banking sector. This is because banks seek to borrow money and pays out short-term rates, and lends back the capital at long-term rates. Though the current ultra-low rates have reduced borrowing costs for banks, it has also has taken a toll on the lending rates, which the bank receives, thereby affecting their net margins.
When interest rates rise, banks would be able to earn more on lending and pay less on deposits. This would expand net margins and boost banks’ profits. Further, U.S. banks now have much stronger balance sheets and their earnings picture continues to improve with economic revival (read: 7 ETFs to Buy in 2014).
Given improving fundamentals, the best way to ride out the surge in this corner of the broad financial market is with SPDR S&P Regional Banking ETF (KRE). This is one of largest and the most popular ETFs in the banking space with AUM of nearly $2.6 billion and average daily volume of more than 3 million shares.
The product follows the S&P Regional Banks Select Industry Index, charging investors 35 basis points a year in fees. Holding 81 securities in its basket, the fund is widely spread out across each security, which minimizes the company specific risk thanks to an equal-weigh approach. However, small cap dominates the fund’s return at 65%, followed by mid caps (24%) and large caps (11%).
The fund added about 4% in the past five trading sessions and currently has a Zacks ETF Rank of 2 or ‘Buy’ with ‘High’ risk outlook.
Insurance companies would benefit from rising interest rates, as these are able to earn higher returns on their investment portfolio of longer-duration bonds. But at the same time, these firms incur loss as the value of longer-duration bonds goes down with rising interest rates.
Nevertheless, since insurance companies have long-term investment horizons, they can hold investments until maturity and hence, no actual losses will be realized. Moreover, the upside to the this sector could be confirmed by the Zacks Industry Rank, as three out of five insurance industries have a solid rank (in the top 33%) at the time of writing (read: Should You Buy Insurance ETFs Now?).
Investors could easily play the sector with iShares U.S. Insurance ETF (IAK), which amassed $156 million in its asset base and sees light volume of around 27,000 shares a day. The fund charges 45 bps in annual fees and tracks the Dow Jones U.S. Select Insurance Index.
In total, the product holds 67 stocks in its basket with the largest allocation going to American International (AIG) at 12%, closely followed by Metlife (MET) at nearly 10%. Other firms do not hold more than 6.8% of total assets. Within the insurance sector, property and casualty insurance takes the top spot, accounting for just less than half of the asset base. Life insurance and full time insurance take the remaining portion in the basket.
The fund was up nearly 1.6% over the five trading days and has a Zacks ETF Rank of ‘1’ or ‘Strong Buy’, with a ‘Medium’ risk outlook.
Broad Financial ETFs
Investors seeking broad exposure to the financial sector could find the ultra-popular Financial Select Sector SPDR Fund (XLF) an interesting choice. The ETF follows the S&P Financial Select Sector Index and manages about $18 billion in asset base. It trades in heavy volume of roughly 41 million shares a day and charges 16 bps in fees per year from investors.
The product holds 84 securities in its basket with Wells Fargo (WFC), Berkshire Hathaway (BRK.B) and JPMorgan Chase (JPM) occupying the top three positions with 8% share each. In terms of industrial exposure, banks take the top spot at 38.3% while insurance (17.59%) and capital markets (13.18%) round off to the top three spots (read: Bank on Dividends with These Financial ETFs).
XLF was up nearly 2.4% over the past five days and has a Zacks ETF Rank of ‘1’ or ‘Strong Buy’, with a ‘Low’ risk outlook.
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