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.

Brett Manning, senior markets analyst at Briefing.com, says this ETF has an intriguing concept because people are beginning to realize the problems rising interest rates may cause portfolios.

“From a marketing standpoint it’s a great idea,” he says, but in the current environment the fund’s structure creates losses.

The fund is in a negative carry at the moment, which makes the cost of holding the ETF more than the yield earned, he says.

As Manning explains it, RISE appears right now to be suffering a problem that’s common to the world of commodity ETFs—namely, negative roll yield. In the case of RISE and its positions in Treasuries, for it to hold a position the fund has to exit the expiring futures month and enter a new contract month by buying back the sold position (covering the short) and selling the new contract month. Currently, the two- and 10-year bond futures price curve shows values falling into the future, known as backwardation. As a result, Manning says, they’re covering high and shorting low when they need to exit.

“It also seems to be a little more expensive in fees,” he says. “It seems to be an admirable mission but I’m not exactly jumping to buy it to hedge my own interest rate exposure. If interest rates go sideways, that’s the problem with backwardation and negative carry. You’re going to lose money on that, plus the fees, if you don’t get a rising rate environment.”

And these inverse bond ETFs are losing money because of the negative carry.

Doty says the combination of negative carry and expenses for RISE is at 3 percent, but if RISE comprised just 10 percent of an investor’s portfolio it would cost them 30 basis points. He says the fund compares favorably in that regard to another inverse bond fund that he sees as RISE’s biggest competitor, the ProShares UltraShort 20+ Year Treasury ETF (TBT), where the negative carry and expense are somewhere between 7 percent and 8 percent because that fund goes out further on the interest rate curve.

“The two-year yield is so low so the negative carry is low,” Doty notes. “The negative carry in the futures contract is dependent on the yield of the underlying Treasury, and the difference between that and the LIBOR (London Interbank Overnight Rate).”

Simply shorting a fund like the iShares 20+ Year Treasury Bond ETF (TLT) also opens the portfolio to more duration risk, and some advisors can’t short ETFs, he says.

The RISE fund is designed for someone who wants more stability or downside protection in their portfolio, Doty says, adding that he has clients who will handle a 5 percent to 10 percent loss in the stock side of their allocation without an issue “but freak out” if the bond side goes down 1 percent.

“Clients of mine that use RISE or the institution rising rate strategy haven’t called me once this year… The people who use these types of hedge strategies can sleep at night,” he says.