As persistent inflation continues to drive up interest rates – with the Bank of Canada recently stating its intention to keep nudging borrowing costs higher – investors can choose from a number of exchange-traded funds that aim to benefit from the current rising-rate environment.
But choosing funds that match your particular goals is key, says Mark Yamada, president and chief executive officer of Toronto-based Pur Investing Inc.
“It really does depend on what the investor is trying to accomplish with an ETF,” he says. “Are they looking for safety or for growth?”
For investors looking to bolster the safety side of their portfolio amid rising rates, Mr. Yamada points to floating-rate senior loan ETFs as one option to consider.
With this type of fund, investors are exposed to bundles of corporate loans and debt securities with interest rates that reset, typically every 90 days, according to the London Interbank Offered Rate (LIBOR) or other international benchmark.
“So you’re not locked in with low rates,” says Mr. Yamada. “As rates have moved higher, the interest on these floating-rate notes are also moving higher, between 3 to 4 per cent currently, which is not great but better than the 1 to 2 per cent we saw in short-term ETFs a year ago.”
First Trust Senior Loan ETF (FSL-T) is the senior-loan fund Pur Investing uses most frequently for its clients, he adds.
“The only thing is, it’s Canadian-dollar-hedged and the U.S. dollar has been strong against the Canadian dollar, so that’s subtracted 2 to 3 per cent off performance in the last year,” he notes.
Laddered-bond ETFs, which hold bonds with different maturity dates that can range from one to 10 years, are also worth a look for investors seeking safety, says Mr. Yamada. Many investors already use a ladder strategy with their direct bond investments or guaranteed investment certificates (GICs). With a laddered-bond ETF, the same principle is in play but with added advantages such as automatic reinvestment of yields – at prevailing rates – into the next series of bonds.
“As interest rates are moving quickly, these laddered ETFs are likely to get hurt more than floating-rate ETFs,” says Mr. Yamada. “But they’re still better than fixed-income ETFs.”
So, what about investors seeking growth-oriented ETFs that align with the upward trend of interest rates?
Daniel Straus, director of ETF research at National Bank Financial, suggests looking at products specifically designed with rising rates in mind.
“There are ETFs that, literally, have ‘rising rate’ in their name,” he says. “The philosophy is based on using quantitative analysis to see which sectors are most correlated in performance to rising rates or most anti-correlated to rising rates.”
One example is ProShares Equities for Rising Rates ETFs (EQRR-Q), a U.S. equity ETF designed to outperform traditional large-cap indices during periods of rising rates. About 60 per cent of the fund is weighted almost equally between the energy and financial sectors, with the remaining in basic materials, industrials and discretionary consumer goods.
“Traditionally sectors like utilities go down when rates go up,” says Mr. Straus, “whereas energy tends to do well.”
Among Canadian-listed funds, there are at least half a dozen dividend ETFs focused on rising rates. As an example, Mr. Straus cites the Fidelity U.S. Dividend for Rising Rates Index ETF (FCRR-T), which provides exposure to American dividend-paying companies with positive correlations to rising interest rates.
Given that lenders’ profit margins tend to get bigger when interest rates go up, ETFs that focus on banks – such as the Hamilton Enhanced Canadian Bank ETF (HCAL-T) – should not be overlooked, says Mr. Straus.
“Banks tend to be able to improve their profit margins when rates go up,” he says. “That’s so well-understood by the Street that when we hear even the slightest whisper of an interest rate hike, we see inflows and huge volumes in bank ETFs. So if you anticipate that rates will go up and you want to be ahead of the curve, then a bank ETF might be a way to do that.”
Elke Rubach, a financial planner and principal at Toronto-based Rubach Wealth, agrees – but with a caveat.
“Because interest rates are rising, ETFs that hold banks and other financial institutions could be a good option,” she says. “However, that should be taken with caution because the banks are going to have to deal with a lot of non-performing loans.”
Indeed, a number of Canadian banks have started to set aside funds as a cushion for an expected wave of loan defaults. Two banks that released earnings figures last month, RBC and Scotiabank, reported hundreds of millions of dollars in provisions from credit losses that ate into otherwise healthy profits.
Investors who want to fare well in a rising rate environment should look also at assets related to products and services that consumers will continue buying, even when higher interest rates are weakening their purchasing power, says Ms. Rubach.
With the next rate hike now a matter of when, not if, many investors are likely scrambling to position their portfolio to either minimize the impact of the increase or take advantage of it – or both.
Robb Engen, a fee-only financial planner at Boomer and Echo in Lethbridge, Alta., cautions against knee-jerk reactions to market events such as inflationary or interest rate cycles. An emotional, panic-driven response inevitably leads to poor portfolio performance, he says.
“Ideally you should already have a portfolio allocation that meets your risk tolerance, designed so that you can stick to it over the long term,” he adds.
There are cases where a few portfolio adjustments may make sense. An investor who’s nearing retirement and wants to start pulling out cash, for example, can break up the bond component of their portfolio and invest in a mix of short-term bonds and GICs, along with high-interest savings.
This is where a high-interest savings ETF like Horizons Cash Maximizer (HSAV-T) may be a good fit, says Mr. Engen.