If you were to meet an alien from newly discovered
exoplanet Ross 128 b, the one thing he's likely to know about Earth is that interest rates are rising. But would he know how to invest in a rising-rate environment? Probably not. He wouldn't be alone. Three exchange-traded funds are designed expressly to deal with rising interest rates, and two aren't doing very well at it.
Much of the unpleasantness in the stock market earlier this month has stemmed from concerns about
rising interest rates, which, in turn, were sparked by concerns about inflation, the Kryptonite for those who depend on interest income.
So far this year, the consumer price index, the government's main gauge of
inflation, jumped a mildly higher than expected (and seasonally adjusted) 0.5% in January. Over the past 12 months, CPI has gained 2.1%. In reaction, the yield on the 10-year Treasury note had jumped to 2.84% Monday, up from 2.40% at the end of 2017.
Rising rates have many unfortunate effects on corporate earnings and stock prices. When rates move higher, companies have to pay more to borrow and expand, which hurts their earnings. A company's dividend yield looks less appealing when compared with a bond yield. And higher rates also means that the value of future earnings declines, forcing analysts to reduce their estimates.
Those three factors alone are enough to create a strong headwind for stocks and bonds. Yet three ETFs market themselves as specifically tailored for rising rates. How did they fare?
We'll start with Fidelity Dividend ETF for Rising Rates (FDRR), which looks for mid-cap and large-cap stocks that pay dividends, grow their payout over time and positive correlation of returns to increasing 10-year U.S. Treasury yields, Fidelity says. The ETF has gained 2.2% in 2018 through Friday, vs. 3.1% for the Standard & Poor's 500 stock index. To its credit, the fund has a current yield of 2.77%, well above the S&P 500's yield of 1.78%, and carries an expense ratio of 0.29%.
The problem with this ETF is that, as far as Wall Street is concerned, rising dividend stocks are so 2016. While the tech-heavy ETF has some rockets in its portfolio, such as Cisco Systems Inc. (CSCO), up 15.6% this year, it also has some duds, most notably in health care, such as Johnson & Johnson (JNJ), down 5.5%.
Next up is ProShares Equities for Rising Rates (EQRR), which invests in 50 stocks that historically have fared well in periods of rising rates. The fund charges an expense ratio of 0.35% and is too young to have a 12-month yield.
Nevertheless, it has beaten Fidelity's offering in 2018, but not by much: It's up 2.4%. The ProShares offering has less technology than the Fidelity fund and a heftier weighting in financial services. Of its five largest holdings, three are banks, one is an insurance company and another is online brokerage ETrade.
The rising rates fund with the best record? It's a nontraditional bond fund: Sit Rising Rate ETF (RISE), up 3.7% — which, incidentally, beats the S&P 500. The ETF uses futures and options to have a negative correlation to Treasury securities. It's not a fund for either the faint of heart or the cheap: RISE has a zero yield and charges 1% in expenses. Presumably, one could have done just as well — and more cheaply — investing in an inverse Treasury fund, such as ProShares Short 20+ Year Treasury (TBF). (To be fair, the Sit fund is weighted toward shorter durations than the ProShares offering).
All three funds are new, said Jim Lowell, editor of Fidelity Investor, a newsletter. "Time will have to be the arbiter of which fund is better or worse."
He noted that the rise in interest rates this year hasn't been as great as the fear of rising rates. "The volatility in the fixed-income marketplace makes this very cloudy."
And, of course, the ETFs can tweak their rules to adjust to new data if and when rates start to take off in earnest. "The joy of factor models is that you can always go back to the model and adjust the rules and factors," Mr. Lowell said.
