Revisiting ETF Asset Allocation As Yields Rise

October 12, 2018

The Federal Reserve has raised rates eight times this cycle, three time this year alone—and many expect another hike before 2018 is over. This week, 10-year Treasury yields hit new highs, briefly climbing above 3.25% to the highest levels since mid-2011.

The ongoing rise—which many expect to continue—has some wondering what to do about asset allocation. Is any sort of rotation out of rate-sensitive assets, including equities, called for? Should investors just stay the course?

As we begin the fourth quarter, we asked ETF strategists to chime in on what they are doing with their portfolios in the face of rising rates. Here’s what they had to say:

Clayton Fresk: Portfolio Manager, Stadion Money Management, Georgia

Generally speaking, we haven’t had any significant rotation as of yet. In some of our more tactical allocations, our fixed-income exposure has remained in ultra-short ETFs for some time. Where we’ve seen tactical rotation out of equities, it’s been more a function of recent equity weakness (particularly in higher-beta segments such as technology and small-caps) rather than a rising rate effect.

In some of our more strategic allocations, we’ve maintained a relatively benchmark neutral fixed-income allocation. All that said, this recent breakout higher on the 10-year definitely has us keeping our eye on our duration exposure.

Ben Lavine: Chief Investment Officer, 3D Asset Management, Connecticut

The fixed-income ETF component of our risk-based models is benchmarked to the Bloomberg Barclays Aggregate Bond Index. We’ve been underweight “effective duration,” or interest rate sensitivity, for the last couple of years in anticipation of a higher interest rate environment. At some point, “duration” will become a buy as long as long-term inflation peaks at current levels, around 2.00-2.25%.

In the global equity sleeve of our risk-based models, we have an allocation to REITs and dividend-paying stocks; we’re a long-term strategic investor, and hold these positions for diversification reasons.

Ben Doty: Senior Investment Director, Koss Olinger, Florida

For bonds, an investor’s compensation for longer duration is the maturity premium, so with the yield curve almost flat, we’re comfortable in ETFs and other funds that have two- to five-year maturities, since you don’t get paid for more interest rate risk.

For equities, our main takeaway from higher rates is that the equity risk premium compresses without a corresponding increase in the earnings yield—the inverse of the P/E ratio. The stocks with historically lowest earnings yield relative to other stocks continue to be growth stocks.

At some point, the relative outperformance of growth stocks has to reverse in favor of value stocks in the U.S., as well as elsewhere. We’re poised to take advantage of this with a position in the Invesco S&P 500 Pure Value ETF (RPV), as an example.

For alternatives, they’ll be favorable if they can provide alternatives to bonds as a ballast to equity exposure. Some alternatives may, in other words, not react negatively to rising interest rates. Yet many alternatives carry their own risks. Merger arbitrage strategies seem to provide sources of total return comparable to bonds, but not by much. In the merger arbitrage space, we’ve used the IQ Merger Arbitrage ETF (MNA) for short periods of time.

John Davi: Chief Executive Officer & Chief Investment Officer, Astoria Portfolio Advisors, New York

We’ve been vocal that the Fed is behind the curve, that the majority of the bond market is overvalued, and most portfolios aren’t prepared for a rising rate environment. We’ve argued extensively that investors should have a higher allocation toward inflation-sensitive assets, they should include more alternatives, and portfolios should be more diversified across factor exposures.

We think there’s more downside in the short term. Earlier this year, liquidity-sensitive assets—such as cryptocurrencies, emerging market equities, China and EM debt—went into a bear market. There’s a reasonable probability that this bear market has clawed its way into the bond space. To stop this bear market from spreading, the Fed should tone down its rate hikes.

In Astoria's Multi Asset Risk Strategy (MARS) ETF Portfolio, we’ve shifted the portfolio to be more defensive in recent quarters. Within U.S. equities, we’ve shifted our exposures toward value and quality. The spread between the Russell 1000 Growth and Value index is the second-highest since 2000. The WisdomTree U.S. Multifactor Fund (USMF) is an alpha-seeking multifactor model that looks at value, quality, momentum and low correlation.

We’ve also increased the quality and shortened duration of our fixed-income ETFs. While we’re very underweight fixed income, our exposures are mostly in the nontraditional credit and interest rate spread space. We own ETFs such as the SPDR Blackstone / GSO Senior Loan ETF (SRLN), the SPDR Bloomberg Barclays Convertible Securities ETF (CWB) and the Vanguard Tax-Exempt Bond ETF (VTEB).

We think inflation is rising, on the margin, and we’ve increased our exposure to inflation-sensitive assets such as the Invesco Optimum Yield Diversified Commodity Strategy No K-1 ETF (PDBC) and the Energy Select Sector SPDR Fund (XLE).

Very few wanted to own alternatives when the S&P 500 rallied the past eight years. If the current breakdown in the stock/bond correlation isn’t a nasty reminder that investors need to diversify from traditional asset classes, we don’t know what is.

Contact Cinthia Murphy at [email protected]

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