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3 Sector ETFs to Avoid as Interest Rates Rise

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Although it looks as if the Fed will not taper that quickly, yields on bonds have already risen. Plus, with solid economic data, the likelihood of a scaling back of QE has increased, putting many investors on edge.

This is because as the Fed hints more at the end of QE or if it actually follows through, interest rates will rise. In such a situation, the defensive sector and high dividend paying stocks would be the worst hit given their sensitivity to rising interest rates. In fact, these stocks have plunged lately as rising bond yields took some steam out from dividend yield plays (read: Defensive Sector ETFs Leading the Market).

This is forcing many investors to reevaluate their portfolios, pretty much across the board. Below, we have highlighted three sector ETFs that could be the biggest losers from the rising rate scenario. Investors should avoid these products in the coming months as these sectors could continue to trade sluggishly if taper talk intensifies:

Utility ETFs

The recent rough trading has pushed the popular utility benchmarks below the S&P 500 when looking at the year-to-date timeframe, suggesting that the beginning of a downtrend may be at hand in this corner of the market.

While part of the reason may be the recent downgrades in a few big utilities, it is also worth noting that these defensive names have outsized yields as well. And when interest rates rise, these become less attractive, dulling the appeal of utilities across the board (read: Utilities ETFs Slump on Downgrades).  

Utilities Select Sector SPDR (XLU)

This is easily the most popular utilities ETF in the American market with more than $5.3 billion in assets, and average daily volume of just under 10 million shares. The product is also a low cost choice, charging investors 18 basis points a year in fees.

The fund holds about 33 securities in its basket, with top weightings going towards Duke Energy (DUK), Southern Co. (SO) and Nextera Energy (NEE). This gives XLU a heavy focus on electric utilities, although multi-utilities account for about 37% of assets as well.

The product focuses mainly on large caps and yields a pretty high level at over 4% in 30-Day SEC terms. However, over the past three months, XLU has lost about 4.5% and currently has a Zacks ETF Rank of 3 or ‘Hold’ with a Medium risk outlook (read: Zacks ETF Rank Guide).

Consumer Staples ETF

Consumer staple stocks have been under stress in recent months as investors are slowly moving into the “riskier” corners of the stock market (i.e. cyclical stocks) and away from defensive ones (read: Buy These ETFs to Profit from "Sector Rotation"). This is because an improving economy, a recovering housing market and surging stocks have added to the “wealth effect”, resulted in rising consumer confidence for the cyclical sectors.

Valuations for consumer staples sector looks overpriced currently and could be vulnerable to the rising interest rates environment. Additionally, many staples companies are tapped out in terms of growth and thus pay solid dividends to investors.

Consumer Staples Select Sector SPDR ETF (XLP)

With an expense ratio of just 18 basis points, XLP is a cheap way of getting diversified exposure to the consumer sector, and is easily the most popular and the oldest fund in the space. The ETF tracks the Consumer Staples Select Sector index and has amassed around $6.2 billion in its asset base.

With holdings of 42 securities, the product allocates higher weights to giants like Procter & Gamble (PG), Coca Cola (KO) and Philip Morris International (PM). From an industry look, household products, tobacco, beverages, and packaged food products account for at least 15% of assets, suggesting a relatively well spread out profile.

The fund added nearly 2.6% in the trailing three months while yields came in above 2.7%. XLP currently has a Zacks ETF Rank of 3 or ‘Hold’ with a Low risk outlook (read: 3 Top Ranked Consumer ETFs to Buy Now).

Mortgage REITs

While this space was extremely popular as the year started, many have begun to think twice about the segment. This is because the possible slowdown of Fed’s asset-purchase program and the possibility of higher rates, along with a general disdain for high yielding securities, could hamper the outlook for these securities going forward (read: REIT ETFs Crushed: Time to Panic?).

Currently, the spread remains high due to the low short-term rates. But, if the spread collapses, profits could tumble for this highly leveraged space, suggesting that they too could be hurt by increased rates.

iShares FTSE NAREIT Mortgage Plus Capped Index Fund (REM)

This is the most popular mREIT ETF with about $1 billion in AUM. The fund tracks the FTSE NAREIT All Mortgage Capped Index and holds 29 securities in its basket. It charges a slightly high, 48 basis points a year in fees (see more in the Zacks ETF Center).

The fund is heavily concentrated across its top securities, as Annaly Capital (NLY) accounts for 18.6% of the total assets alone and American Capital Agency (AGNC) makes up for another 14.4%. The product is well spread across the market spectrum allocating 20% to large caps, 27% to mid caps and the rest to small caps.

Obviously, the yield is the real focus of this fund, as the 30-Day SEC payout comes in at a robust 12.74%. However, the ETF lost over 19% in the past three month time frame.

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