An ETF playbook for navigating the Fed's rate-hiking plans

Published Sat, Mar 19 20228:27 AM EDT

Jesse Pound @/in/jesse-pound @jesserpound

Interest rates are officially rising once again, and active investors should make sure their portfolios are prepared. The Federal Reserve kicked off a rate hike cycle on Wednesday, and the central bank is projecting roughly six more hikes this year alone . Fed Governor Christopher Waller told CNBC on Friday that the central bank may need to do a 50-basis point hike to help tame inflation. Stocks have risen since Wednesday's announcement, though the major market indexes are still well below their record highs. The exchange traded fund space offers investors exposure to strategies for playing rate hikes as well as to sectors that should be able to weather the higher cost of capital. Todd Sohn, technical and ETF strategist at Strategas Securities, said there should be some areas that succeed despite the higher rates. "The equity market can stumble in the initial months, just as it adjusts to a new hiking cycle, but performance for large cap stocks in general is pretty OK," Sohn said. There are some smaller ETFs that are focused on avoiding interest rate risk. The ProShares Equities for Rising Rates ETF (EQRR) , for example, has outperformed the S & P 500 year to date and on Wednesday and Thursday in the immediate aftermath of the Fed's announcement. "It's heavily, heavily overweighted towards energy, financials and mining names. ... And that's where strength has been, especially this year," Sohn said. To be sure, the fund is small and thinly traded compared to major stocks, so investors should be aware that they could see heightened volatility. Of course, the Fed is not the only factor pushing interest rates higher. The hottest inflation the U.S. has seen in decades makes this hiking cycle different from the last few undertaken by the central bank, and it could make for different winners. "The inflation part of this is a huge wild card that we haven't dealt with in a hiking cycle in 40 years. And so that's also why I'd like to be in more real asset plays like energy, materials," Sohn said. Salvatore Bruno, the chief investment officer at IndexIQ, said that value stocks could outperform in this environment, which would likely mean strong performances from those real asset plays. Two funds that outperformed the S & P 500 on Wednesday and Thursday were the SPDR S & P Metals & Mining ETF (XME) and the Materials Select Sector SPDR Fund (XLB) . The materials stock fund has held up slightly better than the S & P 500 in 2022 but is still down for the year. The metals & mining fund, meanwhile, has surged 30% as the prices of precious metals have jumped. Betting on banks? On the negative side, one of the groups most often associated with rising rates could be a disappointment. Conventional wisdom holds that bank stocks perform well when interest rates rise, but the popular Financial Select Sector SPDR Fund (XLF) has actually fallen in the month immediately following the first hike in the last three Fed hiking cycles. Banks and other financials have already outperformed the broader market this year, and bond yields have risen in anticipation of the cuts, so the good news may be already priced in to those stocks. Another potential issue for the financials is that the rates aren't rising in unison across the yield curve, according to Bruno. "I think what's happening, and what we're seeing happening this time, is that even though the Fed is raising on the short end of the curve, the longer end of the curve has been flattening," Bruno said. "So you're looking at an overall flattening of the yield curve. The conventional wisdom is that banks do better as 'interest rates' go up generally, but it's really more the slope of the curve. They finance themselves on the short end and loaning out on the longer end, and that's how they're making they're spread." What about bonds? A rising rate environment could also be a good opportunity for investors to reevaluate their fixed income holdings. Rate hikes from the Fed typically push up bond yields and therefore decrease the price of bonds. However, some funds do let investors gain exposure to bonds with flexible or floating interest rate payouts. The iShares Floating Rate Bond ETF (FLOT) , for example, is mostly flat for the year despite the rise in Treasury yields. Bruno said that another area of fixed income that could make sense for investors is the fallen angel space, which has high yield debt from more established companies. The iShares Fallen Angels USD Bond ETF (FALN) has risen since the Fed announced its hike.

Trader on the floor of the NYSE, March 17, 2022.

Source: NYSE

Interest rates are officially rising once again, and active investors should make sure their portfolios are prepared.