Rate-Proofing A Portfolio With ETFs

With the Federal Reserve's December meeting, just a few days away, there will be plenty of chatter about the impact of higher borrowing costs on equities.

By now, many investors know that certain asset classes and sectors are vulnerable to higher interest rates. Income-generating fare such as master limited partnerships (MLPs), real estate investment trusts (REITs) and utilities stocks are in that category. Conversely, regional bank stocks and exchange-traded funds are perceived to be beneficiaries of hawkish Fed action.

Related Link: Investors Are Pouring Into Bank ETFs Ahead Of Fed Meeting

However, another cyclical sector can also provide investors with protection and profit potential if and when the Federal Reserve gets around to increasing borrowing costs: Technology.

The Tech Advantage

In fact, technology, the largest sector weight in the S&P 500, has historically been one of the best-performing sectors during Fed tightening cycles.

“In addition, technology companies may be poised to outperform other sectors amid higher rates, in large part due to their large cash reserves and strong balance sheets. With limited debt financing, they may be less vulnerable than debt-laden firms due to the higher borrowing costs that result when rates rise. As such, this sector has the potential for sustainable growth and continued shareholder friendly policies even as rates increase,” said BlackRock Global Investment Strategist Heidi Richardson in a recent note.

With interest rates seemingly destined to soon rise, investors might want to have a look at an ETF such as the iShares Dow Jones US Technology (ETF) IYW, which is chock full of cash-rich companies. Dow components Apple Inc. AAPL and Microsoft Corporation MSFT combine for about 30 percent of IYW's weight. Those companies also combine for a cash stockpile north of $300 billion.

“Technology companies hold a staggering 40 percent of the total corporate cash reserves in the U.S., according to Forbes, so they’re much less vulnerable to rising rates than debt-laden firms, such as utilities, according to Bloomberg data as of 07/13/2015. Their strong cash positions mean they have the potential to continue on with their shareholder-friendly policies, such as share buybacks, dividend increases and M&A activity,” according to a recent iShares note.

Technology is a cyclical sector, so its durability against a backdrop of rising rates is not surprising; higher rates should signal the Fed's confidence in the sturdiness of the U.S. economy.

Related Link: How To Use Leveraged ETFs To Beat The Fed

IYW And XLK

IYW's rival, the Technology SPDR (ETF) XLK, lagged the S&P 500 during the last Fed tightening cycle, but XLK has historical data on its side. For months one through 12 after a Fed rate hike, technology is no worse than the second-best sector after energy, according to Bank of America Merrill Lynch data.