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For this article I will be writing about a portfolio of ETF's that is intended to outperform broad bond ETF's during a rising interest rate environment. The reason why I am writing this article is I believe that the problems around the globe that have caused rates to fall to historic lows, are short to medium term in nature and can be fixed/repaired, and can get back to focusing on growth. I thought this would be a good time to write this article and construct the following portfolio since rates are near their lows again. For this portfolio I will be using the Fidelity ETF Screener and ETFdb.com floating rate bond section to find ETF's that match the criteria for the rising rates portfolio.

Reason for Rising Rates Portfolio:

Taking the contrarian side of the market is a little different for me, as I have always been more of a "go with the trend" style, but for the following reason below I ended up being on the contrarian side of the market. The reason I believe rates will rise is that I believe China will be able to turn things around and engineer the "Soft-Landing" everyone always talks about. One major clue on how their efforts are going will come from the ETF that tracks Chinese stocks, the iShares FTSE China 25 Index Fund (NYSEARCA:FXI) which usually tops and bottom's before the US Stock market does. The FXI topped out on February 3rd 2012 and the SPDR S&P 500 (NYSEARCA:SPY) topped out almost exactly to the day 2 months later on April 2nd 2012. The FXI closed at a new low for this year today and the SPY is still roughly 4.5% above its closing low for this year. So that leads me to believe if the SPY falls near or to that low for this year, and at the same time the FXI starts to rise because their soft landing plan is working, I would expect the SPY to turn around shortly after that and with a turn around in the SPY I would expect an accompanies rising of interest rates.

For the portfolio I have a couple criteria/goals for the portfolio, and they are:

  1. If there is more than one fund that meets the screener criteria choose the one with the lowest standard deviation.
  2. Reduce the volatility of the portfolio by weighting the least volatile funds higher than more volatile funds. I used the 3 month average volatility over the last 12 months. [Volatility data is from ETFreplay.com]
  3. For the makeup of the portfolio I wanted Floating Rate Bonds, TIPS Bonds, Emerging Markets Bonds, inverse long Bonds, and A Equity fund.

ETF Screener Selection Criteria:

For the floating rate bond I used the ETFdb.com floating rate section. Then for the other 4 categories of ETF's I wanted to include in the portfolio I used the Fidelity Screener listed above.

Floating Rate ETF Criteria:

  1. For the Floating rate bond criteria, I used the ETFdb.com floating rate bond section and found that there were 3 floating rate ETF's so I chose the fund with the highest assets and volume.

Fidelity Bond ETF Screener Criteria:

  1. Exclude Leveraged and Inverse. [Include inverse ETF only for inverse bond ETF Selection]
  2. ETF Type: ETF
  3. Asset Class: Fixed Income
  4. Net Assets: Greater than $50 Million
  5. Fixed Income Objective: Federal/Central Debt
  6. Volume: 30 day Average volume greater than 50K
  7. Geography Objective: Domestic, Emerging Markets
  8. Leveraged/Inverse Factor: -1x [Only for inverse bond ETF Selection]
  9. Select Standard Deviation (1 Yr) but did not chose value so it just shows the standard deviation for all the funds in the screener table.

Fidelity Equity ETF Screener Criteria:

  1. Exclude Leveraged and Inverse.
  2. ETF Type: ETF
  3. Asset Class: Equity
  4. Net Assets: Greater than $50 Million
  5. Dividend Yield: Greater than 2%.
  6. Volume: 30 day Average volume greater than 50K
  7. Geography Objective: Domestic
  8. Price Performance YTD: Greater than 0%.
  9. Index Composition: Is one of Dividend Weighted or Dividend yield weighted.
  10. Select Standard Deviation (1 Yr) but did not chose value so it just shows the standard deviation for all the funds in the screener table.

Fund Selection Process

Floating Rate Bond ETF:

For this ETF out of the three Floating rate ETF's that were in the ETFdb.com floating rate section and the one by far with the most assets and volume is the iShares Floating Rate Note (NYSEARCA:FLOT), so I included it in the portfolio.

TIPS Bond ETF:

Using the above screener criteria, I found that there were 15 ETF's that met the criteria for federal/central debt, and out of those doing a visual scan of the list there were 6 ETF's that were TIPS related and the one with the lowest standard deviation was the PIMCO 1-5 Year US TIPS Index ETF (NYSEARCA:STPZ), so it was included in the portfolio.

Emerging Markets Bond ETF:

For this fund I used the above screener criteria except I changed the geography objective from domestic to emerging markets and found that 4 ETF's met the criteria and the out of the one with the lowest standard deviation was the PowerShares Emerging Markets Sovereign Debt (NYSEARCA:PCY), so it was included in the portfolio.

Inverse Long Term Bond ETF:

After using the above criteria for inverse bonds, there was only 1 that met them and it was the ProShares Short 20+ Year Treasury (NYSEARCA:TBF), so it was included in the portfolio.

Equity ETF:

Using the criteria for Equity ETF's there were 6 ETF's that met the criteria and the one out of those with the lowest standard deviation was the iShares High Dividend Equity (NYSEARCA:HDV), so it was included in the portfolio.

Portfolio Funds Weighted by Volatility

Symbol

Description

Weight

Volatility

PIMCO 1-5 Year U.S. TIPS Index Fund

30%

1.60%

iShares Floating Rate Note Fund

25%

2.20%

PowerShares Emerging Mkts Sovereign Debt

20%

4.90%

the iShares High Dividend Equity

15%

7.60%

ProShares Short 20+ Year Treasury

10%

14.40%

Returns & Data

[Data from ETFreplay.com]

The first chart and return data are from the short period of this year when we got a taste of rising rates when the 10-year treasury yield went from 1.80% on January 31st 2012, and rose to a closing high for the year of 2.38% on March 19th 2012. The second chart shows the period from the March 19th 2012 2.38% closing high until May 15th 2012 which was the lowest closing rate of the year at 1.78%. The portfolio in the charts is compared to the iShares Barclays Aggregate Bond (NYSEARCA:AGG) ETF.

Rising Rates

(click to enlarge)

Falling Rates

(click to enlarge)

Correlations

Correlation Data from ETFscreen.com

FLOT

HDV

PCY

STPZ

TBF

FLOT

1

HDV

-0.01

1

PCY

0.03

0.3

1

STPZ

0.03

0.12

0.32

1

TBF

0.06

0.56

0.05

-0.21

1

Portfolio Challenges

The biggest challenge for this portfolio is if rates continue to fall, as the second chart shows the portfolio is pretty much a mirror image of AGG, so as long as rates continue to fall the portfolio would have challenges. If the problems with growth slowing in China and the problems in Europe I would expect and what has actually happened is that rates would continue to fall as investors flock to treasuries and the US Dollar for their "Safe-Haven" status. Those two reasons are the biggest reason's I see that will be challenging for the portfolio to outperform AGG.

Closing thoughts

During the period in the first chart when rates sharply rose, the portfolio outperformed AGG by 4% which I was happy with but during the falling rate period AGG outperformed the portfolio by 3.2% which was disappointing but not unexpected. So if my contrarian point listed above come true then I would expect rates to rise and the portfolio to outperform AGG, and if the problems around the world can't be solved then I would expect rates to continue falling.

Disclaimer

Source: Rising Rates ETF Portfolio