Interest rates are on the rise right now, and this is beginning to spook investors. Is there anything to be concerned about? Well, when the herd begins to move, you don’t exactly want to stand in its way. In translation, now is a good time to start preparing for higher rates with the right kind of exchange-traded funds (ETFs) and mutual funds.
The yield on the 10-year Treasury bond recently broke above 1.75%, a 14-month high for this benchmark rate. Why is this a problem? Investors don’t like it because, when yields on low-risk bonds begin to approach the yields for dividend-paying stocks, they begin to rotate their holdings over to the perceived safety of bonds, while receiving the same yields.
And for those investors who don’t care about yield, they still care about avoiding downside price risk caused by herd selling. But for those of us investors who don’t mind taking a moderate degree of risk, there are ETFs and mutual funds that can hold up in a rising rate environment.
Thus, in no particular order, here are seven ETFs and mutual funds for rising interest rates.
- Vanguard Short-Term Inflation Protected Securities (NASDAQ:VTIP)
- iShares Floating Rate Bond ETF (BATS:FLOT)
- Vanguard Financials Index Fund ETF Shares (NYSEARCA:VFH)
- Dodge & Cox Stock Fund (MUTF:DODGX)
- Vanguard Real Estate ETF (NYSEARCA:VNQ)
- Parnassus Endeavor Fund Investor Shares (MUTF:PARWX)
- SPDR Gold Shares (NYSEARCA:GLD)
Now, let’s dive in and take a closer look at each one.
Best ETFs and Mutual Funds for Higher Rates: Vanguard Short-Term Inflation Protected Securities (VTIP)
Expense Ratio: 0.05%, or $5 for every $10,000 invested
Investors can reduce interest rate risk and take advantage of higher inflation at the same time with a bond fund like Vanguard Short-Term Inflation Protected Securities.
Bond prices generally move in the opposite direction of interest rates, and this is especially true for longer maturities. Therefore, to reduce this risk, you can hold short-term bond funds. And since higher inflation often accompanies higher interest rates, fixed-income investors can manage this risk with Treasury inflation-protected securities, or TIPS.
That said, VTIP provides exposure to both of these fixed-income areas in one fund by holding short-term inflation-protected securities. The average duration of holdings in the portfolio is 2.7 years, with 100% allocation to government securities.
iShares Floating Rate Bond ETF (FLOT)
Expense Ratio: 0.20%
Since fixed-income investments tend to lag in a rising rate environment, a bond fund that can fluctuate with interest rates can be a good idea. A fund to apply this strategy with is iShares Floating Rate Bond ETF.
FLOT tracks an index of U.S. floating rate bonds whose interest payments adjust to reflect changes in interest rates. Bond holding maturities range between one month and five years. These short- to intermediate-term maturities will also help to reduce interest rate risk.
Investors that invest in floating rate bond funds are seeking flexible interest in a rising interest rate environment. If you’re thinking about buying a fund like FLOT, keep in mind that the variable rate nature of the fund does not guarantee higher yields in a rising rate environment. The key attraction to floating rate bond funds is to reduce interest rate risk compared to conventional bond funds.
Best ETFs and Mutual Funds for Higher Rates: Vanguard Financials ETF (VFH)
Expense Ratio: 0.10%
When interest rates are rising the financial sector generally performs better than the broader market. The Vanguard Financials ETF offers investors a low-cost means of taking advantage of this trend.
As we mentioned in our story on the best ETFs for coming inflation, a rise in interest rates pushes up profit margins for the big financial companies. This can be especially true for large-cap U.S. financials like VFH top holdings JPMorgan Chase (NYSE:JPM), Berkshire Hathaway (NYSE:BRK.B) and Bank of America (NYSE:BAC).
Put simply, financial stocks can make a good hedge against rising interest rates and VFH is an outstanding fund to make this move now.
Dodge & Cox Stock Fund (DODGX)
Expense Ratio: 0.52%
A high quality actively-managed fund fund like Dodge & Cox Stock Fund can be a smart investment choice in a rising rate environment.
The DODGX portfolio is well-diversified across multiple sectors but its heaviest concentration is in financials, at 28% of the portfolio, which positions the fund well for rising interest rates. Top holdings for DODGX include Capital One Financial (NYSE:COF), Charles Schwab (NYSE:SCHW) and Wells Fargo (NYSE:WFC).
Additionally, DODGX employs a committee approach to management, which has worked well for the Dodge & Cox family of funds in the 40+ years of their existence. The average tenure for DODGX is 14 years, which spans across a group of the worst economies and bear markets in history.
Best ETFs and Mutual Funds for Higher Rates: Vanguard Real Estate (VNQ)
Expense Ratio: 0.12%
Higher interest rates tend to fatten the profits for real estate companies, which makes Vanguard Real Estate a smart holding now.
A simplified way to explain how real estate can be a smart investment during a rising rate environment is to think about the cost of housing. When rates are going up, especially when the economy is booming, home prices and mortgage payments are becoming increasingly unaffordable for the average consumer.
Thus, in a rising rate environment, there is a higher demand for rental properties, which also have higher costs but are still an attractive alternative to an expensive mortgage. Higher demand, plus pricing power for property management firms, makes for a profitable environment. When the economy is booming, hotel properties will also benefit.
VNQ focuses on real estate investment trusts (REITs), including companies that purchase office buildings, hotels, and other real property. Top holdings include American Tower Corp. (NYSE:AMT), Prologis Inc (NYSE:PLD) and Crown Castle International Corp (NYSE:CCI).
Parnassus Endeavor Fund (PARWX)
Expense Ratio: 0.95%
Actively-managed funds like Parnassus Endeavor can be well worth their costs in a rising rate environment. And when the expense ratio is below-average, it’s a bonus.
PARWX is a fund that focuses on companies that meet certain environment, social and governance standards, also known as an ESG fund. But that’s not necessarily the quality that makes PARWX a smart holding when rates are rising. Put simply, PARWX is a standout because it’s a well-managed fund that does an outstanding job of balancing growth and value in a portfolio.
For example, the top sectors of the fund are technology, financials and industrials. These are all areas that can do well when rates are rising, especially with a seasoned management team picking the winners.
Best ETFs and Mutual Funds for Higher Rates: SPDR Gold Shares (GLD)
Expense Ratio: 0.40%
Although there is not a high correlation between interest rates and gold prices, gold ETFs like SPDR Gold Shares can make smart holdings when interest rates are rising.
Gold’s relationship with interest rates can be somewhat complex. What’s important to know is that a rising rate environment tends to place downside pressure in stocks, as investors tend to shift out of higher-priced equities and into higher-yielding bonds. When investors get nervous about stocks, they tend to prefer perceived safe havens like gold.
So, if you’re looking for a defensive move in anticipation of a choppy market ahead, GLD ETF can be a smart move.
On the date of publication, Kent Thune did not personally hold a position in any of the aforementioned securities, although he holds PARWX and GLD in some client accounts. Under no circumstances does this information represent a recommendation to buy or sell securities.