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Can these 3 ETFs guard against rising interest rates?

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Advisors know to keep clients in short-term debt instruments when rates are climbing. But what should you do about equities? Stocks, too, can tumble when rates increase.

Three ETFs purport to offer investors a way to participate in the stock market while lessening the danger posed by rate increases. One even has a dividend focus.

The oldest of these ETFs came to market just over three years ago, and the newest is about to celebrate its first birthday.

Here they are in order of seniority:

The Invesco S&P 500 ex-Rate Sensitive Low Volatility ETF (XLRV, expense ratio: 0.25%) is based on an index that includes the 100 stocks in the S&P 500 that have low volatility and do not perform poorly when 10-year U.S. Treasury rates rise. Selection begins by performing a regression of the prior 60 monthly stock returns of each issue in the S&P 500 to changes in the 10-year U.S. Treasury rate. Realized volatility over the prior 252 days is also computed. Companies are ranked in descending order by rate sensitivity and the 100 most sensitive are eliminated. Of the remaining issues, the 100 with the lowest volatility constitute the index. Financials, industrials and information technology are the largest sectors in XLRV, which went public in April 2015. Morningstar puts the ETF’s indicated yield at 1.85%.

The Fidelity Dividend ETF for Rising Rates (FDRR, 0.29%), launched in September 2016, tracks a proprietary Fidelity index that considers both rising rates and dividends. The selection begins with the 1,000 largest domestic stocks. Non-dividend payers are eliminated as are the 5% with the highest payout ratios. Stocks are given a composite score with factor weightings of 63% for dividend yield, 13.5% for payout ratio, 13.5% for dividend growth and 10% for correlation to 10-year Treasury yields. Composite scores are adjusted to remove size bias in the index. Although mostly a domestic stock ETF, FDRR can have up to 10% of holdings from non-U.S. developed countries. FDRR has 110 holdings with information technology, financials and healthcare the largest sector positions. Morningstar sees FDRR’s indicated yield at 3.65%.

Launched in July 2017, the ProShares Equities for Rising Rates ETF (EQRR, 0.35%) holds 50 large-cap stocks across five sectors. The index selection starts with the 500 largest stocks and evaluates their correlation with the 10-year Treasury yield over the previous three years. The stocks are sorted by sector and the five sectors with the highest positive correlation are selected. In each of these sectors, the 10 stocks with the highest Treasury correlation are picked for the index. Biggest sector positions are energy, financials, and industrials. Morningstar pegs EQRR’s indicated yield at 1.73%.

The short history of these ETFs makes evaluating them difficult. All base their selection on stocks’ sensitivity to changes in the rates on 10-year Treasury notes. XLRV eliminates stocks that do worst when 10-year rates rise, whereas the others favor stocks that do best in that situation.

But right now, we’re seeing much greater increases in short-term rates. Since the beginning of the year, the yield on three-month T-bills has gone up 54 basis points while the yield on the 10-year note has risen 37 basis points. Furthermore, though short-term rates have risen throughout their brief lives, none of these ETFs has had to endure an inverted yield curve, which usually spells hard times for equities.

When financials, which make up major holdings in all three funds, have to borrow at short-term rates that are higher than their long-term lending rates, watch out.

So far this year, two of the three underperformed the Utilities Select Sector SPDR (XLU), a bond surrogate and poster child for negative rate sensitivity.

These ETFs offer interesting concepts that advisors may want to watch carefully before trying.

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