Although the Federal Reserve took no action at its September Federal Open Market Committee, they left the door open for a potential interest rate hike in December. Bond markets get nervous when the Fed looks to act—witness the “taper tantrum” of a few years ago when the Fed just hinted at raising rates.
Some financial advisors seek to minimize downside risk by adding shorter-duration exchange-traded funds or making bets to short, or sell, U.S. Treasury notes.
The Sit Rising Rate ETF (RISE) says it offers investors protection from rising interest rates by placing short positions on futures contracts on two-, five- and 10-year Treasury notes. Eighty percent of this actively-managed fund shorts two- and five-year U.S. Treasury futures. The other 20 percent sells long call options on five-year U.S. Treasury futures and buys put options on U.S. 10-year Treasury futures.
The net result is a negative duration of 10, meaning if interest rates go up 1 percent, the fund gains 10%. That makes it a pure-play bet on rising rates for U.S. investors, says Bryce Doty, portfolio manager for RISE, and head of the taxable bond group for Sit Investments, where he oversees $7 billion for the firm.
The ETF, which launched Feb. 2015, has $10.17 million in assets under management and an expense ratio of 1.50%. Because of the use of futures and options on futures, its legal structure is as a commodities pool, meaning investors get a K-1 at tax time and it’s not covered under the 1940 Investment Company Act.
The one-month return is up 0.39%, and one-year return is down 5%.
Doty says institutional investors approached his firm a few years ago with concerns about the Fed raising rates, so it created the hedge strategy first for its clients before creating the ETF. They decided to sell two- and five-year Treasuries because those are the yields that are going to move the most rapidly when the Fed changes course, he says.
RISE is designed to only occupy a small part of a portfolio. By incorporating 10 percent to 15 percent of the fund as part of the overall bond allocation, it can reduce volatility and lower the duration, Doty says.
“It reduces the volatility. It’s like collision insurance. You want it before the accident occurs, before the Fed moves,” he explains.
To demonstrate how it works, RISE has an “interest rate defense calculator” on its website where potential buyers can plug in figures. For example, a bond portfolio with a 3 percent yield, a 4-year duration that includes a 15 percent RISE allocation would lower the overall yield to 2.10 percent, and the duration to 1.90 years.