Rising inflation can have a significant impact on financial markets, often prompting the U.S. Federal Reserve to increase interest rates to control price surges. While higher interest rates help stabilize inflation, they can also erode corporate earnings and lower bond prices. However, certain types of exchange-traded funds (ETFs) are better positioned to perform well in these conditions.
Although there isn’t a specific category of ETFs designed exclusively for rising interest rates, some funds tend to thrive in such environments. Below, we’ll explore the best ETF types to consider and highlight specific funds that can help you build a resilient portfolio.
ETFs That Perform Well in Rising Rate Environments
Here are the key types of ETFs that typically perform better when interest rates are on the rise:
1. Short-Term Bond ETFs
Short-term bond ETFs are less sensitive to interest rate changes compared to long-term bonds. Bonds with shorter durations experience smaller price declines in response to rising rates, making these funds a safer choice during such periods.
2. TIPS ETFs
Treasury Inflation-Protected Securities (TIPS) ETFs adjust their principal value based on inflation, offering a hedge against rising prices. These funds are especially useful when rising rates coincide with high inflation levels, though they are not entirely risk-free.
3. Floating Rate ETFs
Floating rate ETFs invest in bonds with variable interest rates that adjust with market conditions. These funds are designed to maintain their value during rising interest rate environments, making them an excellent defensive option.
4. Growth Stock ETFs
Rising rates often occur during the later stages of the business cycle, a phase that can favor growth stocks. However, growth stock ETFs carry higher risk, particularly as the economy approaches a potential recession.
5. Financial Sector ETFs
Financial ETFs focus on banks and financial institutions, which can benefit from rising rates due to higher profit margins on loans. These funds often perform well in rate-hike environments but may face challenges during economic downturns.
Top ETFs for Rising Inflation and Interest Rates
Based on these categories, here are five ETFs to consider adding to your portfolio during periods of inflation and rising rates:
1. iShares Short Treasury Bond ETF (SHV)
- Category: Short-Term Bond ETF
- Overview: This ETF invests in U.S. Treasury bonds with maturities under one year, minimizing exposure to interest rate risk.
- Assets: $18.1 billion (as of Nov. 7, 2024)
- Expense Ratio: 0.15% ($15 per $10,000 invested)
- Why It’s a Good Pick: Its short duration provides stability and even the potential for positive returns when rates rise.
2. iShares TIPS Bond ETF (TIP)
- Category: TIPS ETF
- Overview: This is the largest ETF investing in Treasury Inflation-Protected Securities, which adjust for inflation.
- Assets: $16.68 billion (as of Nov. 7, 2024)
- Expense Ratio: 0.19%
- Why It’s a Good Pick: It offers a reliable hedge against inflation while maintaining steady returns during rising rate periods.
3. iShares Floating Rate Bond ETF (FLOT)
- Category: Floating Rate ETF
- Overview: Provides exposure to bonds with variable interest rates, which adjust as market rates change.
- Assets: $7.2 billion (as of Nov. 7, 2024)
- Expense Ratio: 0.15%
- Why It’s a Good Pick: The floating interest rates help maintain value, offering resilience in volatile rate environments.
4. Vanguard Growth ETF (VUG)
- Category: Growth Stock ETF
- Overview: Offers low-cost exposure to a broad range of U.S. large-cap growth stocks.
- Assets: $261.4 billion (as of Nov. 7, 2024)
- Expense Ratio: 0.04%
- Why It’s a Good Pick: Ideal for capturing gains in the later stages of the business cycle with minimal fees.
5. Financial Select Sector SPDR (XLF)
- Category: Financial Sector ETF
- Overview: Focuses on U.S. financial stocks, including banks, brokerage firms, and insurance companies.
- Assets: $47.9 billion (as of Nov. 7, 2024)
- Expense Ratio: 0.09%
- Why It’s a Good Pick: Financial institutions often benefit from rising interest rates due to increased profit margins.
Key Considerations for Investors
While these ETFs are designed to perform well during rising interest rates and inflation, it’s essential to manage your expectations. Even these funds can experience value declines during volatile markets. Diversification remains a critical strategy—ensure your portfolio includes assets from various sectors and categories to reduce risk.
Pro Tip: Limit concentrated investments in any single ETF type to 10%–20% of your portfolio. This approach helps protect against potential losses while maintaining exposure to growth opportunities.
Positioning Your Portfolio for Rising Rates
Rising inflation and interest rate hikes can challenge traditional investment strategies, but they also present opportunities for savvy investors. By focusing on ETFs like short-term bonds, TIPS, floating rate funds, growth stocks, and financial sector funds, you can strengthen your portfolio and potentially benefit from these economic conditions.
Remember, maintaining a diversified portfolio is crucial for long-term success. Before making investment decisions, evaluate your risk tolerance and financial goals. With the right strategy, you can navigate rising inflation and interest rates with confidence and turn these challenges into opportunities for growth.