Fund manager Q&A: Betting on funds that thrive as rates rise

How wary are investors about rising interest rates? Just look at February.

Markets got rattled by signs that inflation might be increasing, raising the possibility that the Federal Reserve would hike interest rates at a faster pace. Such a move, investors fear, would put a brake on the economy and potentially hurt corporate profits.

Last week, concerns of faster-than-expected rate hikes sent the market into a skid after Fed Chairman Jerome Powell said that he was feeling more optimistic about the U.S. economy. Some investors took that as another signal that the central bank may get more aggressive on rates.

The Fed forecast in December that it would raise rates three times in 2018. But many analysts think economic developments might lead the Fed to boost rates four times this year. The first increase could come later this month, when the Fed holds its next policy meeting.

The growing likelihood of a pickup in rates this year is one reason that stocks of banks and other financial companies emerged with gains from last month's correction in the Standard & Poor's 500 index.

Banks tend to get a boost when investors expect interest rates to rise because higher rates allow lenders to charge more for loans.

Investors seeking to hedge against higher interest rates and increased volatility have other options besides traditional retail banks. Financial services companies, like State Street and BlackRock, which issue exchange-traded funds, or ETFs, tend to also do well when rates rise, says Michael Venuto, chief investment officer of Toroso Asset Management.

He says Toroso's ETF Industry Exposure & Financial Services exchange-traded fund, or ETF, is a good play for investors when interest rates and market volatility rise. The ETF, ticker symbol TETF, is up 8 percent this year, while the S&P 500 is up 1.8 percent. Answers have been edited for length and clarity.

Q: What goes into selecting the companies in the fund?

A: The ETF was designed to mirror the growth of the ETF industry. It's focused on all the companies that are aligned with this move toward low-cost, transparent tax-efficient investing. So the major players include BlackRock, WisdomTree, State Street, Charles Schwab. But it also includes things like the exchanges and the liquidity providers. Right now ETFs are 18 percent of the mutual fund world. That's the trend we're trying to capture, but you do get tangential benefits, like rising rates exposure and volatility exposure.

Q: How do these financial services companies benefit from higher interest rates?

A: Companies like a Charles Schwab benefit massively through money market holdings, the cash that people hold. Additionally, when you have rising rates you have money moving. Most of the money when it moves now doesn't go from one stock to another or one mutual fund to another. It's usually going from those instruments to ETFs, because that's just the flow of money today. State Street, our biggest position, is the main custodian for most of these money markets, ETFs and things along those lines. So rising rates can be a huge benefit to companies like Schwab and State Street.

Q: Is this an alternative or a better approach than investing in funds that hold shares in retail banks?

A: A pure bank index would probably be geared better toward a rising rate environment. The problem is a pure bank index is subject to 1,000 other issues that can take away those benefits. Regulations, tariffs. This product is more about the subset of the financial services that's more aligned with the customer.

Q: How big of a factor would it be on stock prices if the Fed ends up speeding up the time table for rate hikes?

A: Markets like stability. They like things that are predictable, and when you bring in something unpredictable, you get volatility. We actually benefit from it. The best-performing stock in our portfolio is a company called Virtu, they're the No. 1 trading firm in the U.S. today. When the market started going batty a couple of weeks ago, Virtu was up 60 percent for the year. (It's now up 75 percent.) When volatility returns they make more money.