Yellen Holds The Cards For Rate-Sensitive ETFs

The Federal Reserve passed on raising interest rates following its October meeting, but Federal Reserve Chair Janet Yellen's comments before Congress earlier Wednesday indicate the Fed chief is mulling a boost to borrowing costs in December.

How investors treat rate-sensitive stocks and exchange-traded funds this time around remains to be seen, but conventional wisdom usually dictates that as Treasury yields rise in anticipation of higher interest rates, market participants ditch sectors such as consumer staples, real estate investment trusts (REITs) and utilities.

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Recent U.S. Equity ETFs Performances

Last month, U.S. equity ETFs added $10 billion in new assets, nearly triple the $3.7 billion that flowed into international equity funds. However, international stock funds retain their year-to-date advantage over their U.S.-focused rivals by a margin of $23.1 billion to $17.7 billion, according to State Street Global Advisors data.

Sector ETFs were once again popular with investors in October, and against the backdrop of low interest rates, market participants piled into rate-sensitive sector funds. For example, utilities ETFs added nearly $210 million in new assets last month, according to State Street data.

“Consumer-related sectors took in a combined $2 billion in October, with the higher growth consumer discretionary the favored consumer segment in 2015. Technology and health care were making headlines with their earnings reports; however, political rhetoric and single stock corporate news weighed on the health care sector from a flow perspective. Meanwhile, tech gathered $1.2 billion in assets and is now positive for the year,” said State Street Vice President David Mazza in a note.

Utilities, Staples And REITs

The Utilities SPDR (ETF) XLU, the largest utilities ETF, has captured nearly $61 million in new assets in the current quarter, but a rate-sensitive sector fund with truly impressive fourth-quarter asset-gathering acumen is the >Consumer Staples Select Sect. SPDR (ETF) XLP. Staples ETFs added over $1.4 billion in new assets last month, and XLP alone has hauled in nearly $470 million since the start of the current quarter.

XLU and utilities are, historically, negatively correlated to changes in interest rates; staples stocks are not far removed from a comparable level of rate sensitivity. However, XLP was spotted hitting all-time highs in late October, and the largest staples ETF now resides less than 3 percent below those highs.

Due to their defensive nature and high dividend yields, utilities stocks and ETFs often trade at premiums to the broader market. However, as AltaVista Research recently noted, it estimates XLU's 2015 price-to-earnings ratio to be 16.1, well below the estimated 17.8 for the S&P 500. That could be of assistance if interest rates rise.

The opposite is true of consumer staples and REITs. AltaVista estimates those groups trade at significant premiums to the S&P 500. For example, XLP's estimated 2015 P/E is 20.7, third-highest among the nine original sector SPDRs. That could prompt investors to seek more compelling valuations if the Fed boosts rates next month.