As rate hikes slow mortgage refinancing, ETF rides to a 27% gain since January

As the Federal Reserve continues to flash warnings that it's leaning on higher interest rates to try and tamp down inflation, the markets are finally starting to recognize the policy as a longer-term pattern, which should trigger some adjustments to investment portfolios.

While it has been a uniquely challenging time for fixed-income investors, one alternative has emerged that's proving to be a solid diversifier.

Launched in October, the FolioBeyond Rising Rates ETF (RISR) is nearing the $100 million mark, which means it will start hitting financial advisers’ radar screens. But the fund’s performance, up nearly 27% this year, might have some advisers wishing they had started paying attention sooner.

The good news is the strategy appears to be on solid footing as long as the Fed doesn’t suddenly reverse course, which is something the Fed rarely does.

“The strategy benefits if rates continue to rise,” said Dean Smith, FolioBeyond's chief strategist and portfolio manager.

“The Fed is telling us in every way they can they are going to continue to raise rates,” Smith said. “Until recently the market didn’t believe them, but the market clearly believes them now.”

The ETF generates returns by buying the interest-only portion of mortgage-backed securities that primarily hold 30-year fixed-rate mortgages. If interest rates were falling, the strategy would suffer because borrowers would refinance and reduce the interest income in the portfolio.

But because there's little incentive to refinance into a mortgage at a higher rate, the strategy is able to ride the negative duration of watching the interest-only debt increase in value as rates climb.

Even if the Fed dials back its current hawkish tone, Smith said a steady Fed policy would benefit the strategy because of the diversification factor, that includes a dividend yield of nearly 6% and a negative correlation to both the stock and bond markets.

This is a thematic strategy and it’s natural to be cautious, as Eric Reinhold, an adviser with Ameriprise Financial Services, explained.

“This looks like a niche product that will work when inflation is in high gear, but what about when it reverses?” Reinhold said. “I liked a niche fund [Amplify Black Swan Growth & Treasury ETF] for clients in 2020-2021, but then it got creamed this year. Not sure either are long-term options, but certainly can work for a time if you pay attention to them.”

Nate Geraci, president of The ETF Store, agreed that these types of thematic strategies might not be ideal buy-and-hold funds. But he does believe they can be useful tools for portfolio diversification in certain market cycles.

“RISR has been one of the real gems in the ETF universe this year,” he said. “The biggest question right now is whether interest-rate risk is to the upside or downside, as there’s a growing camp that believes we may be heading toward a recession. If that occurs, rates could come back in and RISR will underperform. That said, allocating to an ETF like RISR as part of a diversified fixed-income portfolio could certainly prove beneficial if rates continue rising.”

While Geraci was impressed by an upstart ETF provider seeing its first fund grow to nearly $100 million in less than a year, he said the growth might be held back by the relative complexity of the strategy.

This is not your garden-variety fixed-income fund. It invests almost exclusively in interest-only mortgage-backed securities that are created by investment banks that buy the mortgages from the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation.

“The strategy is a bit more complex and thus advisers might shy away from it because they either don’t fully understand it or believe clients may not understand it,” Geraci said.

Another potential deterrent for advisers might be the 1.01% expense ratio.