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How to Profit from Rising Rates with ETFs

Sweta Killa

At its latest FOMC meeting, the Fed raised interest rates for the second time in a decade by a quarter percentage points to 0.50% to 0.75% from 0.25% to 0.50%. Pickup in economic growth since the middle of the year, substantial increase in inflation and a nine-year low unemployment level were cited as the reasons for the rate hike.

The central bank further signaled a faster pace of rate increase next year given President-elect Donald Trump’s tax cut proposals, increased infrastructure spending plans and deregulations. The Fed now expects three lift-offs in 2017, two or more in 2018 and three in 2019.

Additionally, the Fed increased its GDP growth expectation to 1.9% from 1.8% for 2016 and to 2.1% from 2.0% for 2017. GDP growth expectation for 2018 remained unchanged at 2.0% while it was raised by a notch to 1.9% for 2019.  

Pros and Cons

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 (read: Can Dollar ETFs Stay Strong Going into 2017?).

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 increased rates. Higher rates would also result in tighter lending conditions and curtail consumer spending on a wide range of products like cars and houses. This will in turn hurt profitability across various segments.

Against such a backdrop, investors should be well prepared to protect themselves from higher rates. Here are number of ways that could prove extremely beneficial for ETF investors in a rising rate environment:

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 ETFs or products targeting these sectors. Some of the broad ETFs having double-digit exposure to these four sectors are Vanguard Total Stock Market ETF (VTI), 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 top-ranked PowerShares S&P SmallCap Financials Portfolio (PSCF), 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 1 (Strong Buy) or 2 (Buy), suggesting their outperformance in the coming months (read: Tackle Trump & the Fed with These Cyclical Sector ETFs).

Focus Niche Bond 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.

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 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 prices 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 bonds are less vulnerable and better hedges to rising rates (read: 6 Bond ETFs to Play Higher Rates).

While there are several options in this space, PIMCO Enhanced Short Maturity Active Exchange-Traded Fund (MINT), SPDR Barclays 1-3 Month T-Bill ETF (BIL), and iShares Short Maturity Bond ETF (NEAR) with durations of 0.28, 0.14, and 0.33 years, respectively, seem intriguing choices.

Short Rate-Sensitive Sectors

Investors worried about higher interest rates could also go short on rate sensitive sectors like utilities and real estate via ETFs. There are a number of inverse or leveraged inverse products currently available in the market that offer inverse (opposite) exposure to these sectors. While a leveraged play might be a risky option, inverse ETFs are interesting choices and provide hedging strategies in a rising rate environment.

There are a handful of ETFs in this corner of the investing world. ProShares UltraShort Utilities ETF (SDP) is the only inverse ETF in the utility space employing a double-leveraged factor. In the real estate sector, there are three options – ProShares Short Real Estate ETF (REK), ProShares UltraShort Real Estate ETF (SRS) and Direxion Daily Real Estate Bear 3x ETF (DRV) –having leveraged factor of 1, 2 and 3, respectively.