Take advantage as interest rates begin their march higher.
Annual U.S. inflation rates reached 8.5% in March 2022, marking a 40-year high. With the prices of gas, foodstuffs and labor soaring, the Federal Reserve is anticipated to continue a series of aggressive rate hikes. While the Fed approved a 25-basis-point hike in March, the markets have been pricing in a series of aggressive 50-basis-point hikes, a series that started May 4. With yields on the benchmark 10-year Treasury topping 3% recently, investors have been wrestling with falling bond prices and a volatile sideways trading market that has arguably entered bear territory. However, some assets and sectors remain resilient to inflation, with a few even benefiting from it. Short-term bonds have kept their value, and commodities, gold and energy stocks are all up strongly year to date. Here is a list of seven exchange-traded funds, or ETFs, to buy in the current rising rate environment.
Energy Select Sector SPDR Fund (ticker: XLE)
The energy sector has been a standout so far in 2022, with soaring commodity prices elevating the valuations of many companies previously beat down by low oil and natural gas prices during the COVID-19 pandemic. To participate in this momentum, investors can buy XLE, which tracks the performance of 21 U.S. companies involved in the oil, gas, consumable fuel, energy equipment and services industries. Notable top holdings include Exxon Mobil Corp. (XOM) and Chevron Corp. (CVX), which make up about 45% of the ETF altogether. For the year through May 4, XLE is up over 47%, benefiting from strong tail winds. Right now, XLE could be an excellent defensive tilt for a portfolio, especially with its strong 30-day SEC yield of 3%. Holding this ETF will cost an expense ratio of 0.1%.
iShares 0-3 Month Treasury Bond ETF (SGOV)
Fixed-income investors suffered dearly in 2022, with the prices of most bond ETFs plummeting. The threat of rising interest rates causes bond yields to soar. Because bond yields are inversely related to bond prices, this causes the latter to plummet, leaving investors with little downside protection. Longer-duration bonds such as 10- and 20-plus-year Treasurys have suffered greatly in particular due to their higher interest rate sensitivity. A good defensive play here is investing in ultrashort-duration bond ETFs like SGOV instead. SGOV tracks an index of U.S. Treasury bonds with remaining maturities less than or equal to three months, giving it a very low duration of just 0.12 year. This effectively immunizes it from interest rate risk, with the ETF flat year to date despite pending rate hikes. Holding SGOV will cost an expense ratio of 0.12%, currently waived to just 0.03%.
Invesco Optimum Yield Diversified Commodity Strategy No K-1 ETF (PDBC)
An alternative to investing in the energy sector is to buy a derivatives-based commodities fund. These ETFs often have a lower correlation to both stocks and bonds, offering good diversification value. While energy sector stocks are still affected by market risk to a degree, commodities ETFs like PDBC have an entirely different risk profile thanks to their construction. This ETF uses futures contracts to gain exposure to the price of commodities such as zinc, copper, crude oil, natural gas, wheat, sugar and soybeans. As a result, PDBC gained 37% for the year through May 4 as the prices of energy, foodstuffs and raw materials soared. However, PDBC is very volatile and best suited for advanced investors with a high risk tolerance. If you decide to buy, be mindful of the high 0.62% expense ratio.
Vanguard High Dividend ETF (VYM)
With bond prices facing strong headwinds, investors looking for high passive income and yields have increasingly been turning to dividend-paying stocks. These stocks are often those of large-cap, blue-chip companies in so-called boring industries, such as industrials and consumer staples. As a result, they often have lower valuations, which gives them stronger protection in a rising-rate environment compared to growth stocks. A great ETF to buy here is VYM. In 2022, the ETF was nearly flat as of May 4, compared to the 10% retreat of the S&P 500. The strong cohort of 410 high-dividend-paying stocks VYM tracks also gives it an excellent 30-day SEC yield of 2.7%, which can help your portfolio weather a sideways trading market. Best of all, like many Vanguard funds, VYM only costs a very cheap expense ratio of 0.06% to hold.
SPDR Gold MiniShares (GLDM)
Gold’s role in a rising-rate environment is as a store of value. When bonds and stocks both falter, investors flee to the safety of gold. As a “hard” asset with tangible value and use cases in technology, manufacturing and jewelry, gold provides a strong diversification benefit due to its low correlation with both stocks and bonds. A great way to own gold easily is to buy an ETF like GLDM, which tracks the price of actual gold bullion stored in vaults. Compared to owning physical bullion or buying gold mining stocks, GLDM has no storage costs and is more insulated from market risk. Through May 4, GLDM is up 3% so far in 2022, making it one of the few assets to not tumble this year. The ETF also has a very low cost compared with other precious metal ETFs at just 0.10%.
Direxion Daily 20+ Year Treasury Bear ETF (TMV)
As mentioned earlier, rising interest rates cause bond yields to increase, which causes bond prices to decrease as the two are inversely related. Moreover, a concept called bond convexity causes longer-duration bonds to be more sensitive to interest rate changes, thus losing more in a rising-rate environment. Short-term investors and swing traders can potentially use this concept to reap profits by buying TMV, which provides three times the daily inverse performance of the ICE U.S. Treasury 20+ Year Bond Index. Theoretically, if the index goes down 1% in a day, TMV will increase 3%. The key word here is daily. Due to how compounding works, returns past a daily holding period may vary wildly. Thus, TMV is best suited for short-term speculation or hedging purposes. TMV gained an astonishing 78% in 2022 through May 4. Holding this ETF will cost you a high expense ratio of 1%.
ProShares UltraPro Short QQQ (SQQQ)
SQQQ tracks the daily three times leveraged inverse performance of the popular Nasdaq-100 index. Because the Nasdaq-100 is full of mega-cap technology sector growth stocks, it tends to be quite sensitive to rising interest rates. Through May 4, the Nasdaq-100 was down 17%, and it suffered a 4.5% drop on April 29. In contrast, SQQQ gained 41% over the same stretch. Holding SQQQ for short periods could be a good way to hedge against that and even make profits if a big correction ensues. However, remember that SQQQ provides daily resetting leverage. Holding SQQQ for more than a day can result in unexpected returns due to volatility decay and frequent reverse splits. This is evidenced by the fact that SQQQ’s year-to-date returns are not perfectly three times the leveraged inverse of the NASDAQ-100 index. SQQQ will also cost you a high expense ratio of 0.95% to hold.
7 ETFs for a rising interest rate environment:
— Energy Select Sector SPDR Fund (XLE)
— iShares 0-3 Month Treasury Bond ETF (SGOV)
— Invesco Optimum Yield Diversified Commodity Strategy No K-1 ETF (PDBC)
— Vanguard High Dividend ETF (VYM)
— SPDR Gold MiniShares (GLDM)
— Direxion Daily 20+ Year Treasury Bear ETF (TMV)
— ProShares UltraPro Short QQQ (SQQQ)
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Update 05/05/22: This story was published at an earlier date and has been updated with new information.