Sector ETFs To Go Short On Higher Rate Worries

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Bond yields are spiking lately and investors are worried that the Fed will keep interest rates higher for a longer-than-expected period. After hitting a trough of 3.6% in April, the yield on the 10-year Treasury note hit almost a 16-year high to above 4.3%. The 2-year Treasury yield rose to above 5%.

This is expected to take a toll on rate-sensitive, high-yield sectors such as utilities and real estate. When interest rates rise, these sectors, known for the income they generate, fall out of favor as investors gain similar levels of income without any stock risk.

Additionally, homebuilders will also get hurt as higher yields will translate into higher mortgage rates, which, in turn, will discourage people from buying homes and make refinancing expensive.

Overall, higher interest rates will keep borrowing costs up, thereby resulting in lower consumer spending and a decline in economic activities. This will decrease profitability across various segments.

In such a scenario, investors could make a short-term bearish play on the rate-sensitive sectors as they would continue to trade sluggishly if interest rates keep rising. While futures or short-stock approaches are some possibilities, inverse ETFs like ProShares Short Real Estate ETF (REK - Free Report), ProShares UltraShort Real Estate ETF (SRS - Free Report), Direxion Daily Real Estate Bear 3X Shares (DRV - Free Report) and ProShares UltraShort Utilities ETF (SDP - Free Report) might be good options.

Inverse ETFs provide opposite exposure that is a multiple (-1, -2 or -3 times) of the performance of the underlying sector using various investment strategies, such as swaps, futures contracts and other derivative instruments.

Since most of these funds seek to attain their goal on a daily basis, their performance could vary significantly from the inverse performance of the underlying index or benchmark over a longer period than a shorter period (weeks, months or years) due to the compounding effect.

However, these funds are cheaper than direct shorting or utilization of futures contracts. Given this, investors seeking to capitalize on a rising rate scenario in a short span could consider any of the following ETFs, given the bearish outlook for the sectors. Investors should note that each of the products charges 95 bps in annual fees from investors. 

Rates to Remain High 

Federal Reserve Chair Jerome Powell, in the latest meeting, raised interest rates by a quarter-percentage point to 5.25-5.50%, the highest level since March 2001, marking the 11th rate increase. The central bank also signaled the possibility of further increases ahead. The latest minutes from the Fed's July meeting showed that “most” policymakers continued to prioritize the battle against inflation, while “some participants” cited risks to the economy from pushing rates too far.

A raft of strong economic data kept alive fears of interest rates remaining higher for longer. U.S. retail sales came in better than expected, rising 0.7% in July. Additionally, inflation rose for the first time in July after 12 straight months of decline. The Consumer Price Index rose 3.2% year over year, up from an increase of 3% in June, which was the lowest in more than two years. Although inflation has dropped from a peak of 9.1%, it is still significantly above the Federal Reserve's 2% target.

ProShares Short Real Estate ETF (REK)

ProShares Short Real Estate ETF seeks to deliver the inverse return of the daily performance of the S&P Real Estate Select Sector Index. The ETF makes profits when real estate stocks decline and is suitable for hedging purposes against the fall of these stocks. ProShares Short Real Estate ETF has amassed $40.6 million in its asset base while volume is moderate at around 46,000 shares a day.

ProShares UltraShort Real Estate ETF (SRS)

ProShares UltraShort Real Estate ETF offers two times inverse exposure to the performance of the S&P Real Estate Select Sector Index. It has managed assets worth $62.2 million and charges 95 bps in fees per year. ProShares UltraShort Real Estate ETF trades in an average daily volume of 53,000 shares.

Direxion Daily Real Estate Bear 3X Shares (DRV)

Direxion Daily Real Estate Bear 3X Shares seeks to deliver three times the inverse performance of the Real Estate Select Sector Index. It has AUM of $136.6 million and an average daily volume of around 213,000 shares.

ProShares UltraShort Utilities ETF (SDP)

ProShares UltraShort Utilities ETF seeks to deliver twice (2X or 200%) the inverse return of the daily performance of the Dow Jones U.S. Utilities Index. It has $1.5 million in AUM and an average trading volume of nearly 4,000 shares per day.

Bottom Line

Investors should note that these products are suitable only for short-term traders as these are rebalanced on a daily basis.

Still, for ETF investors who are bearish on the securities of the high-yielding sectors in the near term, any of the above products could make an interesting choice. Clearly, a near-term short could be intriguing for those with a high-risk tolerance and a belief that the “trend is the friend” in this corner of the investing world.

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Disclosure: contains statements and statistics that have been obtained from sources believed to be reliable but are not guaranteed as to accuracy or completeness. References to any ...

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