Smart Beta Channel

Smart Beta ETFs for Rising U.S. Interest Rates

Thus far in 2017, iShares Edge MSCI Minimum Volatility USA ETF (USMV) and PowerShares S&P 500 Low Volatility Portfolio (SPLV) have shed a combined $1.3 billion assets. Despite the exposure differences – for example USMV has sector constraints not employed for SPLV — both offer relatively strong exposure to higher-dividend-yielding stocks relative to the S&P 500 index. As the Fed raises rates further this year, a rotation away from these “bond proxies” may occur.

CFRA has Overweight rankings on both ETFs, based on a combination of holdings-level analysis and fund attributes.  More specifically, SPLV and USMV currently earn favorably low risk consideration attributes in our research, which is consistent with the downside protection investors should seek out from a lower-volatility product.

In April 2015, PowerShares S&P 500 ex-Rate Sensitive Low Volatility Portfolio (XRLV) came to market and has $220 million in assets. Similar to the $6.5 billion SPLV, XRLV focuses on the 100 least volatile stocks in the S&P 500 index. But the smaller ETF first excludes stocks that historically have performed poorly in rising interest rate environments. Examples of stocks inside SPLV that do not make the cut for XRLV, include utilities Dominion Resources (D) and Southern Co (SO).

Rather, those and other utilities are replaced in XRLV by other S&P 500 constituents, including industrials stocks Ametek (AME) and J.B Hunt Transport Services (JBHT). Both are CFRA buy recommendations that have medium CFRA qualitative risk considerations.

In 2017, XRLV is up 5.9%, ahead of SPLV’s 5.1%, highlighting the importance of understanding the construction of these index-based products.

Meanwhile, some dividend ETFs, such as SPDR S&P Dividend (SDY 89 Overweight), experienced net outflows year to date despite offering exposure to companies with long-term records of dividend increases. In September 2016, Fidelity Dividend for Rising Rates (FDRR) launched with a twist on the traditional dividend-growth theme. The proprietary index behind FDRR holds companies that are expected to continue to pay and grow their dividends and have a positive correlation of returns to increasing Treasury yields.

Kraft Heinz (KHC) and Wal-Mart (WMT) are among the ETF’s largest consumer staples (9%) holdings and have low CFRA qualitative risk assessments. CFRA equity analyst Joseph Agnese has a buy recommendation on KHC. He thinks the company’s leading market share positions, strong cash flow generation and significant EBITDA margin expansion opportunities positions it well to achieve strong EPS growth over the next three-years.

Despite also launching less than three years ago and with only $94 million in assets, CFRA ranks FDRR as Overweight. Our ranking is helped by favorable CFRA STARS and overall modest risk consideration attributes.

FDRR is up 6.3% year to date, ahead of the 4.5% and 3.5% respective gains for SDY and Fidelity Core Dividend (FDVV 27 Overweight); FDVV focuses on dividend-growth companies but does not incorporate sensitivity to bond yields.

With the Federal Reserve raising rates last week and indicating that gradual rate hikes are to be expected throughout the year, CFRA thinks investors should broaden the range of smart-beta products they consider. While established offerings SDY, SPLV and USMV remain worthy of attention, we contend FDRR and XRLV are next-generation products with some strong attributes.

Todd Rosenbluth is Director of ETF & Mutual Fund Research at CFRA.

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