While a variety of strategies stand to benefit from falling interest rates, some ETFs could fare better than others depending on how quickly rates decline.Nikada/iStockPhoto / Getty Images
The U.S. Federal Reserve Board Board’s first cut to its policy interest rate in four years marks the beginning of a declining interest rate environment and a sea change for investors.
When it comes to exchange-traded funds (ETFs) that could benefit from decreasing rates, the choices are many, says Ryan Jackson, a passive strategies research analyst with Morningstar, Inc. in Chicago.
“Interest rates are a unifying force that feeds into any valuation model,” he says, referring to a Warren Buffet quote that interest rates are to asset prices what gravity is to the apple.
“When they’re lower, there’s just not as much gravity, and you’ll see prices start to pick up.”
Given the expected outcome – especially in Canada with inflation falling to 2 per cent in August – assets ranging from short-term bonds to emerging markets equities could move higher as interest rates decline.
Still, Mr. Jackson says most gains from falling rates have likely been priced in. And some ETFs could fare better than others, depending on whether rates decline faster or slower than expected, and on whether the economy has the “soft landing” that’s been forecasted.
“Forecasts now are less about when cuts will take place and more about when expectations change,” Mr. Jackson says. For example, even a slight uptick in inflation could affect markets negatively and shake investor expectations.
However, should interest rates continue their descent, bond ETFs will be top of mind for investors.
Mr. Jackson says advisors might consider Hartford Total Return Bond ETF HTRB-A with a management expense ratio (MER) of 0.29 per cent. Its annual yield is about 4.2 per cent, and the fund’s total return is about 6.9 per cent year to date.
“It has the maturity profile of a standard bond portfolio, but it takes on a little bit more credit risk than average,” he says about the actively managed ETF. “The main selling point is it’s run by a sound, experienced and well-resourced team” that can adjust to those “expectation changes.”
Yet, the positive impact of falling interest rates may be limited for the fixed income side of the portfolio, says Dan Bortolotti portfolio manager with Bender, Bender and Bortolotti at PWL Capital Inc. in Toronto.
“If you move from short-term bond ETFs to long-term bond ETFs thinking that interest rates are going down over the next year or two, you may be disappointed.”
Rather, the focus for his clients is on managing volatility.
In turn, retired clients have shorter duration bond exposure through Vanguard Canadian Short-Term Bond Index ETF VSB-T with a MER of 0.11 per cent. Its yield is about 2.7 per cent and its total return is about 4.7 per cent year to date.
Should yields rise unexpectedly, that ETF’s value is likely to be less affected than Vanguard Canadian Aggregate Bond Index ETF VAB-T, with a 0.09 per cent MER. Mr. Bortolotti’s clients with longer time horizons typically hold that fund, which has more upside potential in a falling rate environment, he says. Its yield is about 2.9 per cent while its total return is about 4.3 per cent year to date.
Managing lower yields
One key challenge amid falling rates is lower yields from fixed income, says Lois Gregson, senior ETF analyst with FactSet in St. Louis, Mo. “It’s a question of ‘Where else can I get income?’”
One strategy is to increase risk modestly with more corporate bond exposure. She points to BMO High Quality Corporate Bond Index ETF ZQB-T as one option. With a 0.11 per cent MER, about 60 per cent of its 280 holdings are A-rated corporate bonds. The ETF’s average yield is more than 3.1 per cent, along with a 5 per cent year-to-date total return.
Dividend equity strategies are another way to boost income amid lower yields. Ms. Gregson notes investors often gravitate toward real estate ETFs as rates come down. That includes Schwab U.S. REIT ETF SCHH-A with a 0.07 per cent MER. Its yield is close to 3 per cent, and the fund’s price is up about 15 per cent year to date.
The ETF holds major U.S. real estate investment trusts (REITs) such as American Tower Corporation AMT-N, which owns cell towers, and Realty Income Corp. O-N, an industrial REIT.
“Quality, larger multinational stocks also do well because, as the dollar declines, their revenue outside the U.S. often rises,” she adds.
iShares MSCI USA Quality Factor ETF QUAL-A, with a 0.15 per cent MER, offers that exposure, holding companies including Visa Inc. V-N and Microsoft Corp. MSFT-Q. However, the ETF’s yield is only about 1 per cent, although the ETF’s price is up about 21 per cent year to date.
Currency and debt relief
More growth-driven strategies include emerging markets exposure.
A lower U.S. dollar, sparked by easing rates, reduces emerging market companies’ debt burdens, buoying their growth, Ms. Gregson says.
One potential fund to look at is iShares Core MSCI Emerging Markets IMI ETF XEC-T. The ETF has a 0.27 per cent MER, and its price is up about 11 per cent year to date, with about a 2.3 per cent yield.
Small-cap funds also often benefit from lower rates as they, too, face lower debt challenges, Mr. Jackson says.
Schwab U.S. Small-Cap ETF SCHA-A, with a 0.04 per cent MER, “has some good turnover buffers and liquidity requirements that ensure that it’s tradeable and keeps costs down,” he says. “It’s just a thoughtfully constructed broad, small-cap index.”
Owning companies like online auto seller Carvana Co. CVNA-N among its 1,700-plus holdings, the ETF is up about 7.7 per cent year to date with about 1.3 per cent annual yield.
Although choices are abundant, Mr. Bortolotti reiterates portfolio changes today may be a moot gesture.
Instead, he focuses less on shifts in portfolio strategy, such as adding income equity ETFs that may increase portfolio risk, and more on managing client expectations.
“Discussions are really about reminding them … how it’s best not to move too strongly in one direction or the other because it’s almost impossible to get out in front of where rates and the market are headed,” he says.
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