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4 ETFs to Profit from Sector Rotation

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Investors have preferred defensive sectors like utilities or other high yielding securities over the past few months, given heightened volatility and uncertainty despite a soaring stock market. The trend may reverse as the Fed’s latest move will lead to rotation from these sectors into financials, technology, industrials, and consumer discretionary (read: Utilities ETFs Hitting All-Time Highs Amid Market Turmoil).

This is especially true given that the Fed has turned hawkish and will start unwinding its massive $4.5 trillion balance sheet next month. It has also hinted at one more rate hike by the end of this year with three lifts-off in store for 2018.

Higher Rates: Pros & Cons

Higher rates tend to reflect stronger economic conditions and lower the risk of deflation, making many corners of the market tempting to investors. A strong economy is likely to boost capital spending, which should bode well for information technology and industrial sectors. The financial sector will likely benefit from a higher interest rate spread while consumers will also see a boost if the dollar stays strong. Moreover, an improving economy coupled with surging stock market will continue to add wealth effect, resulting in rising consumer confidence.

Higher rates will attract more capital to the country from foreign investors, thereby boosting the U.S. dollar against the basket of other currencies. However, this would have a huge impact on commodity-linked investments, reflecting that a rising rate environment will hurt a number of segments. In particular, high dividend paying sectors such as utilities and real estate would be the worst hit given their higher sensitivity to rising interest rates (read: 5 Hot Global Dividend ETFs).

Further, securities in capital-intensive sectors like telecom will be impacted by higher rates. Higher rates would also result in tighter lending conditions and curtail consumer spending on a wide range of products like cars and houses. This will in turn hurt profitability across various segments.

How to Play?

While there are number of ETFs to tap sector rotation, we have highlighted four funds that are popular and has a solid Zacks ETF Rank #2 (Buy).  

Financial Select Sector SPDR Fund XLF

This is the most popular financial ETF in the space with AUM of $25.6 billion and average daily volume of nearly 68.2 million shares. The fund follows the Financial Select Sector Index, holding 69 stocks in its basket with double-digit allocation to the top two firms - Berkshire Hathaway Inc. (BRK.B - Free Report) and JPMorgan Chase & Co JPM. In terms of industrial exposure, banks take the top spot at 44% while capital markets, insurance, and diversified financial services make up for double-digit exposure each. The fund charges 14 bps in annual fees (read: ETF Investing Lessons from Warren Buffett).

Technology Select Sector SPDR Fund XLK

This most popular technology ETF follows the Technology Select Sector Index and has $17.8 billion in AUM. The fund charges 14 bps in fees per year from investors and trades in heavy volume of more than 10.3 million shares a day on average. It holds about 75 securities in its basket with higher concentration on the top two firms – Apple AAPL and Microsoft MSFT – that accounts for a combined 25.5% of the assets. In terms of industrial exposure, the fund is widely spread across software, Internet software & services, hardware storage & peripherals, IT services, and semiconductors that make up for a double-digit allocation each.

Industrial Select Sector SPDR XLI

This is the most popular ETF in the industrial space with AUM of $10.5 billion and an average daily volume of more than 9.2 million shares. The fund follows the Industrial Select Sector Index, holding 70 stocks in its basket with each accounting for less than 6.8% of the assets. About one-fourth of the assets is allocated to aerospace & defense while industrial conglomerates, and machinery make up for a double-digit share each. This ETF charges 14 bps in fees per year (read: 5 Solid Reasons to Buy Industrial ETFs Now).

Vanguard Consumer Discretionary ETF VCR

This fund follows the MSCI U.S. Investable Market Consumer Discretionary 25/50 Index and holds 375 stocks in its basket with heavy concentration on Amazon (AMZN) at 12.5%. Internet & direct marketing retail, cable & satellite, and movies & entertainment are the top three sectors accounting for a double-digit exposure each. VCR charges investors 10 bps in annual fees while volume is moderate at nearly 66,000 shares a day. The product manages an asset base of about $2.2 billion.

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