Rate Hikes Back In Play: ETFs To Profit

The interest rate hike surprisingly is back on the table for the summer months as per the April Fed minutes. The minutes revealed that the Fed intends to raise rates in June if economic growth picks up in the second-quarter, inflation climbs and the labor market continues to improve. And this is exactly what is happening in the economy (read: Fed to Hike in June? Expected ETF Moves).

Upbeat Data Supportive of Rates Hike

The recent slew of upbeat data reflects that the economy is off to a strong start in the second quarter after a stalling in the first. This is especially true, as inflation increased 0.4% in April, representing the largest increase in more than three years. This has resulted in year-over year increase in inflation of 1.1% against 0.9% in March. Industrial production increased 0.7% in April after two straight months of declines.

In addition, retail sales jumped 1.3% last month, representing the largest gain since March 2015, buoyed by online shopping. Consumer confidence bounced back to its strongest level in nearly a year in May, with the preliminary University of Michigan sentiment index reading 95.8, up from 89 in April.

Additionally, the housing market is showing signs of a spring rebound given that new home construction and building permits rebounded in April. All these data points bolstered the second-quarter growth prospects leading to the belief that the Fed is much closer to lift rates than Wall Street expectations (read: Homebuilder ETFs to Buy on Upbeat Data).

As a result, expectation for higher rates ticked up to 26% for June, up from single digits since the release of the minutes, according to CME Group (NASDAQ:CME). Further, the hawkish comments from the Fed officials – William Dudley, James Bullard and John Williams – also favor the raising interest rates.

Given the recently improving fundamentals, an increase in rates seems justified. As a result, investor should focus on areas/sectors that will benefit the most in the rising rate environment. Here, we have detailed four of these and their best ETFs below:

Financials

A rising interest rate scenario would be 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 3 or a ‘Hold’ rating with a Medium risk outlook.

This is by far the most popular financial ETF in the space with AUM of $16.6 billion and an average daily volume of about 53.3 million shares. The fund follows the Financial Select Sector Index, holding 93 stocks in its basket. It is heavily concentrated on the top three firms – Berkshire Hathaway (NYSE:BRKa) BRK.B, JPMorgan Chase (NYSE:JPM) and Wells Fargo (NYSE:WFC) – that accounts for one-fourth of the portfolio. In terms of industrial exposure, banks take the top spot at 34.3% while REITs, insurance, diversified financial services and capital markets make up for a double-digit exposure each. The fund charges 14 bps in annual fees and has gained 3% over the past five days (read: Bank ETFs Surge: Will the Momentum Last?).

Consumer Discretionary

Consumer discretionary stocks also seem to good bets in a rising rate scenario. This is because these typically perform well in an improving economy justified by a healing job market, a recovering housing market, and expanding economic activities. Further cheap fuel is an added advantage for this sector. One exciting pick in this space can be Vanguard Consumer Discretionary ETF (HN:VCR) , which has a Zacks ETF Rank of 1 or a ‘Strong Buy’ rating with a Medium risk outlook.

This fund follows the MSCI U.S. Investable Market Consumer Discretionary 25/50 Index and holds 384 stocks in its basket. This is the low choice in the space, charging investors just 10 bps in annual fees while volume is also solid at nearly 130,000 shares a day. The product has managed over $1.8 billion in its asset base so far. It is pretty spread out across sectors and securities with a slight tilt toward Amazon (NASDAQ:AMZN) at 8.8%, while other firms hold no more than 5.7% share. Internet retail, movies and entertainment, restaurants, and cable & satellite are the top four sectors accounting for over 10% of total assets. VCR has gained 0.4% in the same timeframe (read: Forget Broader Retail; Bet on Online Retail ETFs).

Short-Term Treasury

Though the fixed income world is the worst hit by the rising rates scenario, a number of ETFs that employ some niche strategies like iPath US Treasury Steepener ETN STPP could lead to huge gains. This product directly capitalizes on rising interest rates and performs better when the yield curve is rising. The ETN looks to follow the Barclays (LON:BARC) US Treasury 2Y/10Y Yield Curve Index, which delivers returns from the steepening of the yield curve through a notional rolling investment in U.S. Treasury note futures contracts.

The fund takes a weighted long position in two-year Treasury futures contracts and a weighted short position in 10-year Treasury futures contracts. STPP charges 0.75% in fees and expenses while volume is light at around 29,000 shares a day. Additionally, it is an unpopular bond ETF with AUM of just $3.8 million. The note has surged 0.9% over the past week.

Negative Duration Bond

Negative duration bond ETFs 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 $13.2 million and average daily volume of 4,000 shares (see: all the Total Bond ETFs here).

This ETF tracks the Barclays Rate Hedged U.S. Aggregate Bond Index, Negative Five Duration. The benchmark provides long positions in the Barclays US Aggregate Bond Index, which consists of Treasuries, government bonds, corporate bonds, mortgage-backed pass-through securities, commercial MBS & ABS, and short positions in U.S. Treasuries corresponding to a duration exceeding the long portfolio, with duration of approximately negative five years. Expense ratio came in at 28 bps. The product has gained 0.4% over the past five days.

Inverse ETFs

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 (read: Should You Short S&P 500 with ETFs This Summer?).

In this regard, ProShares Short Real Estate ETF (V:REK) seeks to deliver the inverse return of the daily performance of the Dow Jones U.S. Real Estate Index. The product has amassed $29.4 million in its asset base while volume is moderate at around 23,000 shares a day. Expense ratio came in at 0.95%.