Ten ETFs To Own If (When) The Fed Raises Rates

With interest rates still hovering just above zero and growing concerns over an unavoidable uptick in inflation, many investors are anticipating that the Federal Reserve will have no choice but to raise rates from their historically low levels in the near future. Ben Bernanke, the Chairman of the Fed, recently unveiled a strategy to unwind and exit some of the many programs that the Fed rolled out after the market crash of 2008. These programs quickly grew the Fed’s balance sheet to over $2 trillion and Bernanke has vowed to shrink this number but he currently finds himself in a precarious position that is sure to alienate some no matter how the Chairman exits the programs. “If the Fed seeks to shrink its balance sheet quickly, Bernanke could be blamed for taking losses,” writes Kevin Hall. “If the Fed’s balance sheet stays large, critics may see this policy change as a subsidy in the payment of high interest rates to banks.” This delicate balancing act will be a difficult test for Bernanke, who must also juggle the threat of a double dip with the risks of inflation eroding the purchasing power of ordinary Americans and driving away foreign creditors.

Most stocks tend to do very poorly in a rising interest rate environment due to the higher borrowing costs and the increased attractiveness of other investment vehicles, such as CDs. However, there are still several ways for investors to make money when rates inevitably rise with ETFs. Based in part on a detailed report that examines how various asset classes and sector perform during various stages of the tightening cycle, we have come up with ten ETFs that could benefit once the Fed eventually starts raising rates:

1. Short Treasury: ProShares Short 20+ Year Treasury (TBF: 49.94 -0.20 -0.40%)

An increase in the Fed Funds rate has a ripple effect throughout the economy. One of the first securities to be impacted are Treasury bonds, since market rates will obviously rise in tandem with the interest rate hikes. This generally sends bond prices lower, since the fixed coupon rate they offer becomes less attractive relative to new issues at higher rates. This is especially true for longer-term securities that are more sensitive to interest rate changes. One ETF that takes advantage of this is TBF, which seeks to deliver the inverse of the Barclays Capital U.S. 20+ Year Treasury Index. Should interest rates rise, investors in TBF could benefit.

2. Long Dollar: PowerShares DB USD Index Bullish Fund (UUP: 23.63 +0.08 +0.34%)

Worries about a potential debt crisis in the euro-zone have given the dollar a boost in recent weeks, and the greenback could get another boost from a hike in interest rates. Higher rates make dollar-denominated fixed income investments more attractive, thereby increasing demand for the currency against major rivals. The key to this fund’s performance may be the relative increase of U.S. rates: if the Fed hikes rates before other developed economies, the U.S. dollar could appreciate and pump up UUP.

3. WisdomTree International Hedged Equity Fund (HEDJ: 44.38 -0.48 -1.07%)

If a stronger dollar is in the future, most international investments could suffer from some adverse exchange rate impacts, as gains in local markets will translate to fewer dollars. HEDJ alleviates this problem by maintaining a dollar-hedged investment in the EAFE region, trimming away the currency risk of international investing.

Developed market equities may or may not perform well as rates rise, but the prospect of a rallying dollar highlights an issue that most investors ignore when making international equity allocations. For more about how HEDJ works and how it may be beneficial to international investors, see this feature.

4. HOLDRS Merrill Lynch Pharmaceutical (PPH: 64.80 +0.06 +0.09%)

Early Tightening Winners & Losers
Outperform	Underperform
Auto & Parts	Banks
Chemicals	Industrials
Software/Hardware	Oil & Gas
Leisure & Entertainment	Real Estate
Media	Aerospace
General Retail	Insurance
Steel & Materials	Tobacco
Source: cnn.com

According to a Merrill Lynch study, one of the sectors of the market that generally does well both in the early and late phases of a tightening cycle is the pharmaceutical industry. While the reasons for this outperformance are up for debate, some argue that pharmaceutical firms are able to better take advantage of inflationary conditions that are generally prevalent in early stages of a tightening cycle and are able to match rising costs with increased prices. Pharma is also a defensive play since consumers are unlikely to cut back on medicine and related products, a potential boost in the late stages of a tightening cycle.

5. Vanguard Information Tech ETF (VGT: 51.70 +0.12 +0.23%)

Hardware and software firms have also generally performed well during the early part of a tightening cycle. As firms see the increased cost of hiring new workers and expanding production lines thanks to increased borrowing costs, some turn to information technology in order to help keep costs down and make processes as efficient as possible. Funds like VGT, which consists of stocks such as Cisco and IBM, potentially stand to benefit as firms look to technology to cut costs before borrowing more money at increased rates.

6. Money Market ETFs

For investors looking to reduce volatility and fearful of volatile equity markets, money market ETFs may become an increasingly attractive option. While most money market funds are currently offering near-zero yields due to record low interest rates, a spike in rates or inflation could send the yield for these short term instruments higher, offering investors a safe place to stash cash while most stocks and bond prices presumably take a short-term hit. See a head-to-head comparison of money market ETFs.

7. PowerShares Dynamic Leisure & Entertainment Portfolio (PEJ: 13.54 +0.112 +0.83%)

In the initial stages of a rate hike, leisure and entertainment stocks stand to benefit since these firms are generally able to use inflation to obtain better pricing power (and profits) for hotels and other leisure activities. These types of securities also generally underperform in the six months preceding a rate hike, which could allow investors to buy in at discounted prices and “cruise” to gains as inflation hits.

8. PowerShares Dynamic Media (PBS: 11.56 -0.01 -0.09%)

A curious outperformer in a rising rate environment is the media sector. In fact, the early stages of a rate hike cycle seems to be the only time that media stocks outperform the general market. A possible reason for this is that since inflation is usually high in the early phase of a tightening cycle, debt-laden media firms are able to pay off obligations more easily, since the market value of such debt drops. Moreover, since many media firms are not looking to borrow further, it is possible that they are not as affected by the uptick in borrowing costs.

9. SPDR S&P Retail ETF (XRT: 35.45 +0.01 +0.03%)

Another historical beneficiary of interest rate hikes is the retail sector, as the process of buying goods at today’s prices and selling them later at more inflated ones expands profit margins. However, as consumers buckle down to face high interest costs late in the cycle, retail ETFs tend to struggle since more consumer money must go to debt payments instead of buying discretionary items.

10. Market Vectors Steel Index ETF (SLX: 57.31 +0.12 +0.21%)

Steel firms are generally able to pass on inflationary pressures to consumers, so they are able to more easily weather interest rate hikes. Since steel production tends to be a capital-intensive business, most firms have high levels of debt and benefit from the initial inflation and its effects on their debt loads. However, later in the tightening cycle steel stocks tend to underperform due to decreased demand, as most steel consuming firms cut down on capital heavy projects in order to avoid high debt costs. For this reason, investors must be careful when looking at steel stocks over a full interest rate cycle.

For an in-depth look at interest rates and how they affect equities, see this report from the last time the fed raised rates.