Don't Mess With These ETFs If Interest Rates Rise

It is not a stretch to say nearly all market participants know the Federal Reserve meets this week, nor is it a stretch to say those market participants are divided over whether or not the central bank will proceed with raising interest rates.

Fed funds futures indicate traders are not betting the Fed boosts borrowing costs and there is no shortage of commentary and punditry opining that the Fed has missed its window of opportunity to raise rates.

Bottom line: The Fed will or will not raise interest rates this week. Bottom line, part two: Some sectors outperform others immediately following and for months after a Fed rate hike. As Benzinga reported last week, Bank of America Merrill Lynch examined the sectors that perform well after Fed liftoff, those that disappointed and those that were somewhere in the middle. Bank of America used the prior six tightening cycles beginning March 1983, January 1987, March 1988, February 1994, June 1999 and June 2004.

Deeper Dive

BofA's research suggests that Energy Select Sector SPDR XLE and the Technology Select Sector SPDR XLK perform well after Fed raises rates. But wait, there's more. The bank also looked into the sectors that lag following the unveiling of higher interest rates.

Related Link: Nibbling At Risk With ETFs In The Week Ahead

It is not surprising that the telecom and utilities sectors were among the laggards on BofA's post-rate hike list.

"Telecom was the worst or second worst performing sector in terms of average cumulative returns in 6 out of the 12 months following Fed liftoff,” said BofA in a note out last week. The bank added “utilities were lackluster throughout the 12 months after Fed liftoff.”

In terms of ETFs, it is worth remembering that the Utilities Select Sector SPDR XLU is the most negatively correlated to interest rates among the nine sector SPDRs. If the Fed does raise rates, this week or any other time, it might be wise to avoid the Vanguard Telecommunication Services ETF VOX and the iShares U.S. Telecommunications ETF IYZ.

Surprise

The surprise for investors when it comes to sector ETFs to buy in the wake of a Fed rate hike comes in the form of the ETFs not to buy, those being financial services funds. For the all talk of ETFs such as the Financial Services Select Sector SPDR XLF needing higher interest rates as an upside catalyst, the historical data cited by BofA does not support that case.

In nine of the 12 months following Fed liftoff, financials were the worst or second-worst performing sector, according to BofA.

“Banks, Financials, and Telecom had negative average absolute returns 12-months after an initial Fed rate hike,” said the bank.

In the third quarter, it appears that investors are not buying into the notion that financial services ETFs could be disappointments if the Fed hikes rates. XLF, the largest financial services ETF, and the Vanguard Financial Services VFH have lost just $110 million combined in the current quarter.