Interest rates are rising, and according to market expectations, the climb may not be over. To no one’s surprise, rising rates immediately trigger conversations on how to effectively hedge rate risk in bond portfolios, which is critical. But it also opens the door to explore unique portfolios that can be powerful solutions for rate risk in equities.
Key Takeaways
- Rising rates impact equity duration, and high-growth stocks sit particularly vulnerable.
- Equities can play offense, not just defense, in a rising rate environment.
- Specialized ETFs offer targeted equity exposure offering distinct paths to hedge rate and inflation risk by targeting yield-correlated sectors, dividend sustainability, pricing power, and real asset allocations.
This week, in a conversation with the team at ProShares, I was reminded that while bonds get deserved center-stage attention when the topic is interest rates, equities, too, have a mixed history of performance during rising rate periods. There are risks as well as opportunities to consider in this environment.
As a general rule for equity investors, rising rates can impact valuations because higher rates increase the discount rate applied to future earnings. That math problem is especially problematic for high-growth equities that have cash flows projected far into the future.
High free cash flow and value ETFs, then, come into focus as natural solutions to any investor looking to shorten a portfolio’s equity duration, hedging against rate spikes. From an asset flow perspective, we’ve seen demand grow for exposure to these types of strategies.
See More: Rising Rates Not a Dealbreaker for Stocks
More Ways to Tackle the Rising Rate Challenge
Consider four unique ETFs that aren’t in any way a comprehensive list of strategies available. They are examples of some of the shaper tools designed specifically for the rate challenge:
The fund is a straightforward approach that tackles interest rate risk through security selection and sector exposures. It picks U.S. large-cap stocks that have historically demonstrated a positive correlation with rising 10-year Treasury yields.
To quote Kieran Kirwan, investment strategist at ProShares, in a recent webcast: “You don't necessarily have to only think about playing defense when we have rising rates. There's an opportunity here to play offense and be more assertive in your equity portfolio.”
EQRR essentially focuses on a sector and a stock’s correlation to rates going back three years, and dynamically adjusts exposure based on results. The fund always owns five sectors and 50 stocks in the portfolio. Sectors that are most correlated to the 10-year yield get the most weight. The highest-correlated-to-yields stocks in each of these sectors are then selected, and are equal-weighted.
While it may be right to assume that this portfolio would lean heavily on energy and financials, today it has over 35% tied to information technology. Year-to-date, EQRR is up 32%.
EQRR came to market in 2017 as a first-of-a-kind strategy designed specifically to outperform a standard large cap index during periods of rising rates.
See More: Navigating a Changing Rate Environment
FDRR selects dividend-paying stocks with strong balance sheets, healthy cash flows, and historically positive correlation to 10-year Treasury yields.
The strategy focuses on dividend sustainability paired with interest rate sensitivity. Securities within each sector are evaluated on a “Composite Dividend Score” consisting of different factor measures like dividend yield, dividend growth, and rate correlation.
Sector weightings are kept close to the overall market benchmark to prevent sector concentration, though active weights within sectors favor higher-yielding, rate-positive companies. The portfolio, which has over 125 holdings, has tech, financials, and healthcare currently leading sector exposures. FDRR is up 13% this year.
FCPI focuses on large- and midcap equities that have strong pricing power, earnings growth, and low valuation multiples. The idea here is that companies with pricing power can pass rising costs on to consumers, preserving margins as interest rates rise.
The strategy, which fishes for names in the Russell 1000 universe, hones in on sectors that perform well during inflationary periods, and applies a modified market-cap-weighting approach combining composite factor scores with market capitalization.
Nvidia, Apple, Microsoft, and Alphabet are the fund’s largest holdings currently, showing that you don’t have to give up on growth to mitigate rate risk.
PPI blends a mix of equities and real assets in a strategy designed to generate capital appreciation in rising-rate, high-inflationary environments.
The actively managed portfolio uses a quantitative, factor-based process to select and weight holdings. Here, allocations to assets like gold and copper (through physical ETFs) go hand in hand with an equity allocation that includes names like ExxonMobil and Caterpillar.
To quote the firm, “Real assets are a core allocation, but it can be challenging to maintain the right combination of investments. With PPI, investors do not have to worry about allocating to the appropriate assets at the right time.”
All Eyes on Rates
A look at the CME FedWatch tool shows that whether in October (20% chance), or most likely, in December (overwhelmingly likely to happen), the market is pricing in at least one more rate hike this year.
As an investor, tackling potential rate impact on an equity allocation is possible and easy to do with ETFs. Whether through high cash flows or value-focused ETFs, or through sector-driven rising-rate equity strategies — to say nothing of multi-asset, managed futures and others — there are many paths to tackling rate risk.
Rising rates aren’t, after all, only an issue for a bond allocation. They can negatively impact, or prop open opportunities in your equity sleeve too.
For more news information and analysis, visit the Equity ETF Content Hub.
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Read more articles by Cinthia Murphy
