Asset Classes That Outperform When Interest Rates Rise

A rising-rate environment presents opportunities for those keen enough to position themselves in the right corners of the market. Knowing which asset classes have historically outperformed during Fed monetary tightening cycles is pivotal for active investors looking to beat broad benchmarks.

Consider the following research from leading authority TIAA–CREF which sheds a perspective on portfolio allocations during periods of rising interest rates at home.

The performance of each index is relative to a benchmark from three months prior to the first Fed rate hike to 12 months afterwards. The base benchmark for equities and alternatives is the Russell 3000 Index, and for fixed income the Barclays US Aggregate Bond Index.

Below we’re going to highlight ETF types that correspond to the asset classes deemed to offer the most compelling historical outperformance during periods of rising interest rates. Our criteria for “most compelling” is looking at the asset classes that have outperformed (column 3 from the table above) in more than 50% of tightening cycle periods.

In the broad Fixed Income asset class, this includes:

• Inflation-Protected Securities
• Emerging-Market Bonds
• Mortgage-Backed Securities
• High-Yield
• Asset-Backed

Some key considerations here are to focus on debt-based ETFs with a short-term duration so any unexpected increases in the pace of the rate hikes doesn’t have a detrimental impact on your portfolio’s fixed-income component. Remember that while it’s important to maximize yield, you don’t want to find yourself stretching to take unnecessary risks; this might include opting for a higher-yielding EM bond or junk bond ETF in lieu of a lower-yielding one despite the former boasting higher interest rate risk based on the underlying portfolio.

In the Equities asset class, the corners you want to zoom in on are:

• Global Ex-US
• Emerging Markets
• Dividend-Paying

Some considerations when shopping for an equity ETF are:

• Take note of any over-concentrations to top 10 holdings or any one sector in particular.
• If you’re hesitant about EM stocks, consider using currency-hedged ETFs to alleviate some of the uncertainty.
• If you’re more aggressive and in your early investing days, it makes more sense to invest in small cap-focused foreign equity ETFs in lieu of more popular large-cap ones
• Consider using alternative-weighted (e.g. smart beta) ETFs that are still passive but attempt to outperform broad benchmarks

See also 5 Core Smart Beta ETFs You Need in Your Portfolio.

In the Alternatives asset class, investors may consider real estate via REITs. However, there’s some key nuances to take into account when investing in the real estate investment trust space. For periods of rising rates in particular, historical research suggests some rate-sensitive corners of the REIT market, like hotel and self-storage, might be less favorably positioned than others like health care REITs, for example. The takeaway here is to take a good look under the hood of any REIT ETFs you are considering to make sure you’re aware of their composition in order to better judge if it’s suited for a rising-rate environment.

Keep in mind that ETFs were designed with simplicity in mind, so don’t feel burdened to change your allocations too much just because a certain economic theme is getting coverage in the media. When you do rebalance your portfolio for a rising-rate environment, be sure to look for the lowest-cost ETF that suits your objective; minimizing fees is a surefire way to increase your returns without lifting a finger.

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