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7 Stock ETFs to Play a Rate-Increase Cycle

This article was originally published on ETFTrends.com.

As the Federal Reserve normalizes its monetary policy with higher interest rates ahead, U.S. equities and stock ETFs may continue to strengthen in an improving economic environment.

"The Fed tends to raise rates at times when it thinks the economy shows signs of overheating—to tighten credit and reduce the chance of rampant inflation. But while rates are rising and the economy is still growing at a healthy rate, it isn’t uncommon for a general bullishness about stocks to prevail," Dr. Derek Horstmeyer, an assistant professor of finance at George Mason University’s Business School, said on the Wall Street Journal.

Over the past five rate-hike cycles, the S&P 500 averaged a 13.2% return per year, compared to its historical average of 9.6%. The outperformance is also most concentrated in smaller businesses and those in cyclical industries.

Dr. Horstmeyer pointed out that over the past 30 years, an average small-cap mutual fund would have gained an extra 3.62 percentage points more than a large-cap fund per year over the five rate-increase cycles.

Investors who are interested in gaining exposure to the smaller segment of the U.S. equity market also have a number of ETF options to choose from, including iShares Russell 2000 ETF (IWM) , iShares Core S&P Small-Cap ETF (IJR) , Vanguard Small Cap ETF (VB) and Schwab U.S. Small-Cap ETF (SCHA) .

Dr. Horstmeyer also highlighted the outperformance of growth and cyclical stocks during rising interest rate environments. Growth stocks and cyclical industries outpaced value and defensive stocks by 4.65 percentage point per year during the rate-increase cycles.

Targeted ETF Plays

ETF investors can also gain exposure to growth-oriented U.S. equities through more targeted ETFs. For example, S&P 500 growth stocks ETFs include options like the iShares S&P 500 Growth ETF (IVW) , Vanguard S&P 500 Growth ETF (VOOG) and SPDR S&P 500 Growth ETF (SPYG) .

However, the outperformance does not come without risks. Funds that focus on small-caps and growth stocks have come with slightly elevated levels of volatility over those same rate-increase cycles, compared to their safe counterparts, Dr. Horstmeyer warned.

"But in finance, the bigger rewards do tend to come with the bigger risks," Dr. Horstmeyer said.

"Thus, with the Fed showing no signs of letting up on rate increases for the next year, it may be the riskier types of funds, rather than those that invest in safe, dividend-paying and large-cap stocks, that deliver the bigger rewards," he added.