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Stock, Bond ETF Strategies to Fight Rising Rates

This article was originally published on ETFTrends.com.

Investors should be careful when navigating the current environment and consider some ETF investment vehicles that are designed to outperform when interest rates rise.

On the recent webcast (available On Demand for CE Credit), Fight the Fed’s Rising Rates with Floating Rates, Kevin Flanagan, Senior Fixed Income Strategist at WisdomTree, highlighted a number of factors that market watchers have to consider, including the recent tax cut and increased spending expected to boost economic growth by a few percentage points; inflation expectations have risen; and the increasing U.S. budget deficits leading to increased Treasury supply, coming at a time when the Federal Reserve is pulling back on their reinvestments.

Overall, we can anticipate further strengthening in the economy, which will lead to a tighter monetary policy out of the Fed. For instance, the government recently revealed the U.S. economy expanded at a 4.1% rate, its best quarterly performance since 2014. The steady growth has also translated to rising inflation.

Meanwhile, fixed-income investors may find it harder to generate stable returns through traditional bond exposures or a heavy tilt toward U.S. Treasuries. Flanagan warned that the U.S. budget deficit has widened and the Treasury Department has been increasing supply of U.S. Treasuries - Treasury supply for the fiscal year 2018 is expected to be in the $1 trillion to $1.5 trillion range, compared to the $519 billion issued for the fiscal year 2017. On the demand side, the Federal Reserve, which has been a huge buyer of government debt, is now cutting back and steering toward normalization rates.

Consequently, investors will have to adapt their portfolios to meet the changing environment. Flanagan argued that fixed-income investors can find a "Fed-centric" solution by looking to a floating rate strategy, such as the WisdomTree Bloomberg Floating Rate Treasury Fund (USFR) . Since their launch in 2014, Floating Rate Notes have outperformed short-term T-bills. Floating-rate notes have a weekly reset and can more quickly adjust to higher rates as opposed to locking in a static yield for several months.

"Given the potential for additional rate hikes in 2018 & 2019 ‘Fed protection’ seems warranted," Flanagan said.

Furthermore, investors can also look to enhance their yield generation as a way to mitigate potential pullbacks. Something like the WisdomTree Barclays U.S. Aggregate Bond Enhanced Yield Fund (AGGY) or WisdomTree Barclays Yield Enhanced U.S. Short-Term Aggregate Bond Fund (SHAG) can increase income potential of core fixed income while continuing to benefit from the risk mitigation and diversification of a multi-sector portfolio.

These enhanced or smart beta bond ETFs can maintain familiar risk profiles, are overweight in credit and underweights in Treasuries, and potentially generate higher income within defined risk constraints. When comparing the underlying Bloomberg Barclays U.S. Aggregate Enhanced Yield Index to the benchmark Bloomberg Barclays U.S. Aggregate Index, the Enhanced Yield methodology has a lower tilt toward U.S. Treasuries, which may experience greater rate risk ahead, and ups its exposure to credit to improve yield generation.

Joseph Tenaglia, Asset Allocation Strategist at WisdomTree, also warned that stock investors shouldn't forget about the risks of rising interest rates on their equity portfolios.

"Rising yields have had a positive relationship with stocks when yields are low, but rising yields at higher levels have typically been a detriment to stocks," Tenaglia said.

Specifically, Tenaglia pointed out that when interest rates rose less than 0.5%, the size and value factors outperformed. When interest rates rose 0.5% to 1.0%, the momentum factor outperformed. Lastly, when interest rates rose more than 1%, the size factor outperformed while the low-volatility factor exhibited a big underperformance.

Tengalia partially attributed the outperformance of the size factor or to small-cap companies due to the fact that more than half of the Russell 2000’s debt is floating rate, compared to less than 30% in the S&P 500. Additionally, rising interest rates could pressure companies with insufficient earnings to cover increasing interest obligations

Consequently, stock investors who are concerned about rising interest rates should lean towards quality, mid- and small-caps with a focus on fundamentals through the WisdomTree MidCap Earnings Fund (EZM) and WisdomTree SmallCap Earnings Fund (EES) . People can also seek low correlation over low volatility with the WisdomTree U.S. Multifactor Fund (Cboe:USMF) . Lastly, investors can also look to "DivProxiesidend Growers" over bonds through something like the WisdomTree U.S. Quality Dividend Growth Fund (DGRW) .

Financial advisors who are interested in learning more about strategies for a rising rate environment can watch the webcast here on demand.