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Fed to Tighten Policy: Bet on These ETFs

Sweta Killa

The latest Fed minutes hint at another rate hike as early as next month but cast doubts on further increases this year. This is especially true as the Fed plans to start shrinking its $4.5 trillion balance sheet by the end of the year. The unwinding of the balance sheet will reduce the chance of more rate hikes this year.

As per the minutes, the central bank would use a system where cap limits will be implemented on how much the Fed would roll off every month without reinvesting. Any amount it receives in repayments that exceeds the cap limit will be reinvested. The bank has been reinvesting the proceeds from these bonds since recession and rolling them to prop up the U.S. economy. Now, the decision of not reinvesting maturing bonds would act as monetary tightening and lower demand for money, leaving an adverse effect on global liquidity.

Most analysts also suspect further lift-offs this year if economic data continue to disappoint and inflation doesn't gain momentum. Additionally, concerns over Washington turmoil could lead to political uncertainty and delays in pro-growth reforms, resulting in slow economic growth (read: Political Turmoil Triggers Sell-Off: 5 Sector ETFs Hit Hard).

Following the minutes, the odds for a June rate hike remains at 78% per the Fed funds’ futures while CME Group's FedWatch tool shows 83.1% probability.

Given this, investors should continue to focus on areas/sectors that will benefit the most from the Fed’s tightening policy. Here, we have detailed four of these and their best ETFs below:

Financials

A rising interest rate scenario is highly profitable for the financial sector. This is because the steepening yield curve would bolster profits for banks, insurance companies, and discount brokerage firms. A broad way to play this trend is with Financial Select Sector SPDR Fund XLF, which has a Zacks ETF Rank of 1 or a Strong Buy rating with a Medium risk outlook.

This is the most popular financial ETF in the space with AUM of $21.9 billion and an average daily volume of about 72.8 million shares. The fund follows the Financial Select Sector Index, holding 67 stocks in its basket. It is heavily concentrated on the top five firms that collectively make up for 38% of the portfolio while other firms hold no more than 5.93% share. In terms of industrial exposure, banks take the top spot at 44.9% while capital markets, insurance, and diversified financial services make up for double-digit exposure each. The fund charges 14 bps in annual fees and is up 1.8% in the year-to-date timeframe.

Consumer Discretionary

Consumer discretionary stocks also seem good bets. This is because tight policy is seemingly the result of a pickup in economic growth supported by sold job growth, wage growth and increased lending activity that result in higher spending power. One exciting pick in this space can be Vanguard Consumer Discretionary ETF VCR, which has a Zacks ETF Rank of 3 or a Hold rating with a Medium risk outlook (read: Top-Ranked ETFs That Crushed S&P 500 in the Bull Market).

This fund follows the MSCI U.S. Investable Market Consumer Discretionary 25/50 Index and holds 375 stocks in its basket. This is the low choice in the space, charging investors only 10 bps in annual fees while volume is moderate at nearly 87,000 shares a day. The product has managed over $2.2 billion in its asset base so far and is slightly tilted toward the top firm at 11.6%. Other firms hold less than 6% of assets. In terms of industrial exposure, Internet & direct marketing retail, cable & satellite, and movies and entertainment occupy the top spots with a double-digit exposure each. VCR has gained 9.7% in the same timeframe.

Technology

In a tight policy era, technology seems one of the safest sectors as most of the companies are sitting on a huge cash pile. The cash reserves will ensure that these companies are not plagued by any financial trouble even in a rising interest rate environment. While there are several ETFs to bet on, First Trust NASDAQ-100-Technology Sector Index Fund QTEC could be an intriguing option. The fund is on the fire this year, having gained 22.1% so far.    

This ETF tracks the NASDAQ-100 Technology Sector Index, holding 35 stocks in its basket with almost equal allocation. From an industry look, semiconductors dominates the list with 42% share while software and Internet take decent allocations of respectively 26.9% and 16.7% in the portfolio. QTEC is a large cap centric fund with AUM of $2.1 billion and average daily volume of around 219,000 shares. It charges 60 bps in annual fees and has a Zacks ETF Rank of 1 with a High risk outlook (read: 5 ETFs & Stocks to Ride the Tech Mania).

Negative Duration Bond

A tight policy would raise short-term rates, thereby leading to an increase in yields and dulling demand for bonds. Amid such a scenario, focus on negative duration bond ETFs seems prudent as these offer exposure to traditional bonds while at the same time short Treasury bonds using derivatives such as interest-rate swaps, interest-rate options and Treasury futures. The short position will diminish the fund’s actual long duration, resulting in a negative duration. As a result, these bonds could act as a powerful hedge and a money enhancer in a rising rate environment.

Currently, there are a couple of negative duration bond ETFs of which WisdomTree Barclays U.S. Aggregate Bond Negative Duration Fund AGND has AUM of $17.4 million and average daily volume of 5,000 shares. Expense ratio comes in at 0.28%. The product has added 0.5% so far this year (see: all the Total Bond ETFs here).

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SPDR-FINL SELS (XLF): ETF Research Reports
 
VIPERS-CONS DIS (VCR): ETF Research Reports
 
WISDMTR-B USABN (AGND): ETF Research Reports
 
FIRST N-100 TEC (QTEC): ETF Research Reports
 
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