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Reducing Interest Rate Risk With Equity Income ETFs

By: David Fabian
Posted: 12/4/2013 3:46:00 PM
Referenced Stocks: DVY;PFF;SYLD;TDIV

One of the biggest conundrums that income investors face heading into 2014 is how to anticipate the move in interest rates. Nearly every week we get more economic data that seems to support the dreaded “taper” scenario of the Fed easing off the bond buying gas pedal. In addition, we are swiftly approaching a new era of Federal Reserve leadership under Janet Yellen, who will be tasked with reading the tea leaves with respect to timing the Fed’s exit strategy.

With so many factors in play, it begs the question of whether we will see a break higher or lower in rates next year and how that will impact both bonds and stocks. More importantly, I want to focus on how to position your portfolio to insulate yourself from these risks while still taking advantage of income producing opportunities.

A quick look at the 10-Year Treasury Note Yield shows that it is drifting back towards the top end of its range since hitting a high in September. This has put pressure on assets with the highest sensitivity to interest rates such as treasury bonds, REITs, and high-grade corporate bonds.

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Many noted fixed-income managers such as Bill Gross and Jeff Gundlach have taken an agnostic view towards the direction of interest rates and I tend to agree with that strategy in the short-term. As a trend follower, I have been advocating selling long duration securities in favor of shorter duration holdings with a risk management mindset. I am focusing my fixed-income exposure into ETFs and mutual funds that have an overweight allocation to high yield, bank loans, and other performing sectors.

In addition, I think it makes sense to diversify your exposure to areas of the market that offer alternative dividend streams or enhanced value propositions. One of my favorite equity income ETFs to accomplish this is through the First Trust NASDAQ Technology Dividend Index (TDIV). I like this fund because it gives you exposure to a subset of technology stocks that are focused on returning value to shareholders through cash dividends. The current 30-day SEC yield is 2.51% and distributions are paid on a quarterly basis.

Another ETF to consider is the Cambria Shareholder Yield ETF (SYLD) which focuses on 100 stocks that are paying strong dividends, buying back shares, and reducing debt. The investment managers believe that these three pillars represent the best characteristics of companies returning free cash flow to shareholders. This actively managed ETF was launched earlier this year and has already accumulated more than $170 million in assets.

The benefit of investing in ETFs such as TDIV and SYLD is that you get exposure to income producing assets that aren’t directly tied to the daily swings in interest rates. They can also help balance out your portfolio and offer greater capital appreciation opportunity than fixed-income assuming the uptrend in stocks remains intact. Lastly, I think that they offer improved fundamental index characteristics over a traditional broad-based equity income fund such as the iShares Select Dividend ETF (DVY).

From an alternative standpoint, I like the value proposition of preferred stocks as well. The iShares U.S. Preferred Stock ETF (PFF) is currently sporting a yield of nearly 6% and offers compelling characteristics of both equities and bonds. One of the advantages of preferred stocks is their non-correlated returns, as PFF currently has a beta to the S&P 500 of just 0.32. This ETF has been much less volatile than other interest rate sensitive names since it bottomed in August and its dividends are paid monthly.

How To Incorporate These ETFs In Your Portfolio

Your adoption of these unique equity income ETFs will likely depend on your current asset allocation, risk tolerance, and time horizon. The key to incorporating them into your portfolio will be to start small and add to the holdings over time by using price to your advantage.

For portfolios that are overweight fixed-income, I think that these will provide some balance and much needed diversification. In addition, they still offer attractive valuation opportunities over other high flying sectors of the equity market.