Rate Hikes Could Bring Quality ETFs Into Focus | ETF Trends

Domestic equity markets are off to a dismal start in 2022 as inflationary pressures and interest rate hike jitters grip market participants.

Among the worst offenders in early 2022 are previously high-flying growth shares of companies that aren’t yet profitable. With those types of stocks out of favor, that could be a sign that quality fare is back in style, potentially boding well for exchange traded funds, such as the Invesco S&P 500 Quality ETF (NYSEArca: SPHQ).

“As the Federal Reserve moves closer to raising interest rates, investors are repricing their bets on one of the riskiest corners of the market: shares of companies that don’t make money,” reports the Wall Street Journal. “Cash-burning technology firms, biotechnology companies without any approved drugs and startups that listed quickly via mergers with blank-check companies—some of which soared during the pandemic—have dropped sharply.”

The proof is in the quality pudding. Year-to-date, SPHQ is outperforming the S&P 500 by 116 basis points and the Nasdaq-100 by 413 basis points. SPHQ follows the S&P 500 Quality Index. The $3.67 billion fund holds 102 stocks, and with return on equity (ROE) being one of the barometers for entry into the fund’s underlying index, it’s reasonable to assume that many of the ETF’s holdings aren’t just profitable, but are growing earnings as well.

Look at SPHQ this way: Markets are currently displaying an overt disdain for growth companies, including tech, that aren’t making money. However, SPHQ allocates 34.34% of its weight to tech stocks and is outperforming broader benchmarks to start 2022. That’s because SPHQ’s tech holdings are high-quality, cash-rich companies such as Apple (NASDAQ:AAPL) and Microsoft (NASDAQ:MSFT), among others.

The status of SPHQ member firms as profitable companies is particularly meaningful to investors ahead of the Fed’s rate tightening cycle, which could commence as soon as March.

“A Wall Street Journal data analysis shows that, as Fed officials’ signals and continued high-inflation readouts made it clearer that rate increases were looming, shares of unprofitable companies in the Nasdaq Composite Index have skidded while their profitable counterparts have traded nearly flat,” according to Journal.

SPHQ further offsets interest rate risk by allocating 26% of its weight to financial services stocks. That’s the sector most positively correlated to rising 10-year Treasury yields. Conversely, the ETF’s exposure to rate-sensitive real estate and utilities stocks is barely noticeable at a combined weight of just 0.50%.

For more news, information, and strategy, visit the ETF Education Channel.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.