This latest article in our fund spotlight series focuses on ETFs that own Preferred Shares. Preferred shares have become popular in today’s low interest rate environment as investors reach for higher yield. Preferred shares offer yields today in excess of 6%, but at what cost?

In this article we give an explanation of preferred shares, show their advantages and disadvantages in a portfolio, see what some of the most successful investors think of preferred shares and highlight some ETFs that make owning a diversified set of preferred shares easy.

 

If you are brand new to the idea of preferred shares, visit our “Preferred Shares” page in our definition section where we have a 1,000+ word, 6 page explanation of preferred shares along with some important precautions to consider before investing in preferred shares.

 

Preferred shares are popular primarily because of the high yields they offer investors. In fact, all the ETFs below yield around 6%! But, there is no such thing as a free lunch on Wall Street. So what do investors sacrifice in order to get that kind of yield in a time when the 10 year treasury only yields 2%?

 

Very Little Price Appreciation in Rising Markets, Very Little Protection in Falling Markets

The term beta refers to the correlation of a fund’s performance compared to the S&P 500. If a fund has a beta of 2 means that for every 1% the S&P 500 moves, the fund would move 2%. A beta of 0.5 would mean that for every 1% the S&P 500 moved, the fund would move 0.5%. A fund with a beta of 1 should move in lock step with the S&P 500.

These funds have very low beta, which has resulted in little price appreciation compared to the S&P 500 in its latest run up:

Below – the green line represents the S&P 500 index, the blue line represents one of the ETFs we will spotlight below.

(click to enlarge the image below)

As the general stock market has taken off, preferred shares have lagged behind. Investors in preferred shares today are giving up share price appreciation in exchange for a consistent higher dividend yield.

 

However, these funds have failed to protect investors to the downside as witnessed in 2008/2009:

Historically, preferred shares seem to underperform in rising and falling markets. So what is an investor to do with them? We will get into their specific role in a portfolio later in this article.

 

Ability for securities to be called away

As discussed on the preferred share definition page, preferred securities can be called away (bought back by the company) at any time past their call date. This leads to either; 1) Investors having to spend a lot of time managing a portfolio of preferred shares because they may be constantly called away (probably a main reason these funds below have high expense ratios) and/or, 2) Investors taking a loss on their principal investment if they purchased the security above its call price.

This leads to a lot of uncertainty for investors. You may be dependent on the income from preferred shares or be expecting price stability with a long future of dividend payouts, only to have your shares purchased back at an unexpected time.

 

 

With all of that in mind, let’s highlight a few of the big preferred share ETFs available to investors:

 

PFF – iShares U.S. Preferred Stock ETF

Some key statistics:

• Currently yields 5.95%
• Expense ratio of 0.48%
• Currently holds 307 different securities.
• Tracks the iShares S&P U.S. Preferred Stock Index
• Dividends paid monthly

 

As we are about to see in all of these preferred stock ETFs, the main issuer of preferred shares are financial companies.  So investing in these ETFs exposes you significantly to the financial sector (Hence the underperformance in 2008/2009). PFF’s allocation to financial companies is the lowest of all the funds listed here with “only” 66% allocated to the financial sector.

 

iShare’s website for PFF is found here: http://us.ishares.com/product_info/fund/overview/PFF.htm

Prospectus for PFF is found here: http://prospectus-express.newriver.com/summary.asp?clientid=isharesll&fundid=464288687&doctype=pros

Holdings of PFF:

 

All of the funds spotlighted in this article are going to have much higher expense ratios than you are used to seeing on Begin To Invest. Preferred shares are a unique asset class, and as mentioned above require a lot more maintenance than a portfolio benchmarked to the S&P 500. That is one big drawback on these funds. Keep the high expense ratios in mind as you determine if preferred share ETFs are right for your portfolio.

We will look at the performance of this fund along with all the other funds featured at the end of the article.

 

 

PGX – PowerShares Preferred Portfolio

• Current yield of 6.37%
• Expense ratio of 0.50%
• Currently holds 171 different securities
• Heavily weighted in the financial sector (90%)
• Tracks the BofA Merrill Lynch Core Plus Fixed Rate Preferred Securities Index
• Dividends paid monthly

 

 

Powershare’s website for PGX is found here: http://www.invescopowershares.com/products/overview.aspx?ticker=PGX

PGX prospectus can be found here: http://www.invescopowershares.com/pdf/P-PS-PRO-9.pdf

 

Holdings of PGX:

 

PGF – The PowerShares Financial Preferred Portfolio

If 90% of your assets in financial companies wasn’t enough in PGX, they also offer an ETF with 100% preferred shares of financial companies!

• Current yield of 6.24%
• Expense Ratio of 0.66%
• 59 holdings, all within the financial industry
• Tracks the Wells Fargo Hybrid and Preferred Securities Financial Index
• Dividends paid monthly

 

 

Powershares PGF website is found here: http://www.invescopowershares.com/products/overview.aspx?ticker=PGF

The prospectus for PGF is found here: http://www.invescopowershares.com/pdf/P-PS-PRO-1.pdf

 

Holdings of PGF:

 

 

PSK – SPDRWells Fargo Preferred Stock ETF

·         6.39% current yield
·         Expense Ratio of 0.45%
·         133 different holdings, 80% of which are in the financial sector
·         Tracks the Wells Fargo Hybrid and Preferred Securities Aggregate Index
·         Dividends paid quarterly

Note: The fee’s on PSK may rise after October of 2013. The fund has adopted a “Distribution and Service (12b-1) plan, which is explained in great detail be the Wall Street Journal here: http://online.wsj.com/article/SB10001424052748704009804575309011863641700.html

Bottom line for investors, this means a potential increase in fees of 0.25% after the fund directors vote in October 2013.  Be sure to check the links below for up to date information.

PSK Holdings:

SPDR’s website for PSK is found here: https://www.spdrs.com/product/fund.seam?ticker=PSK

The prospectus for PSK is found here: https://www.spdrs.com/library-content/public/SPDR_SUM%20PRO_PSK.pdf

 

 

Fund Performance

 

To find out where preferred shares fit into your portfolio, let’s see how preferred shares have performed compared to the general market.

Below we compare each of the funds above with the S&P 500 index and Vanguard’s total bond market fund, ticker symbol BND.  Do these preferred shares perform like stocks? Like bonds? Or are they different all together?

 

You can see Preferred Shares perform nothing like bonds. In fact during the crisis of 2008/2009 preferred shares performed much worse than an S&P 500 index fund! (PGF down nearly 75% at one time!)

Where both bonds and stocks are positive over the last 5 years, preferred shares are still sharply negative. Of course, most of this is due to the preferred shares being mostly issued from companies in the financial sector, which has taken a beating during the last 5 years. You can see below how these preferred stock funds have compared to a financial sector stock ETF, SPDR’s XLF:

The sour performance of the financial sector stocks has been dragging the performance of their preferred shares also.

Investors in preferred shares have seen underperformance in steep market declines and steep market advances the past 5 years
In Conclusion

So why the buzz about preferred stock? In the yield hungry market of today, preferred shares have received a lot of attention.  After all, there are not many places to get a 6% yield anymore. But in turn investors give up a lot of potential returns and add a lot of risk to their portfolios. These funds underperformed during the bear market of 2008/2009 and are underperforming in the bull market we are seeing now. So what’s an investor to do?

 

Many people make the mistake of replacing bonds with preferred shares in their portfolio for the increase in yield, but as the charts above show that is a grave mistake as it exposes you to a lot more downside in the event of a market drop. Bonds are there to protect your principal, something that preferred shares do not do.

 

But in a neutral market type of year (S&P 500 up or down only a few percent – whenever those happen again) preferred shares can offer some decent returns and supplemental income. Unfortunately, no one has any way of knowing how long a calm market will last and when volatility will come back, and if you are invested in these preferred shares when volatility returns, you will underperform.

Benjamin Graham despised preferred shares and cautioned investors to stay away from them in “The Intelligent Investor“; saying that they offer the worst combination of characteristics of stocks and bonds. They don’t offer the protection that bonds do, and they don’t perform like stocks do – and we have seen that in the charts above. Graham writes in his book “The Intelligent Investor” about preferred shares:

“Certain general observations should be made here on the subject of preferred stocks. Really good preferred stocks can and do exist, but they are good in spite of their investment form, which is an inherently bad one. The typical preferred shareholder is dependent for his safety on the ability and desire of the company to pay dividends on its common stock. Once the common dividends are omitted, or even in danger, his own position becomes precarious, for the directors are under no obligation to continue paying him unless they also pay on the common. On the other hand, the typical preferred stock carries no share in the company’s profits beyond the fixed dividend rate. Thus the preferred holder lacks both the legal claim of the bondholder (or creditor) and the profit possibilities of a common shareholder (or partner).”

 

However today’s investing stars like Warren Buffett seem to love preferred shares lately, and have loaded up on the preferred shares of many financial institutions like Goldman Sachs and Bank of America. However being the world’s third richest man has some perks, including negotiating power with these big companies. The truth is, the everyday investor like you and me cannot get the same deal that Buffett has negotiated with the big banks. His shares are far superior to ones available publicly on the stock exchange. So don’t be too quick to buy preferred stock just because you see Buffett doing it.

 

Forbes had a great article talking about some of these differences between the preferred shares that Buffett received compared to the ones available to you and me.

To quote Forbes:

“There are two parts to this deal that have benefits not available to the public. I’ll start with the warrant. A warrant is a contract to buy shares directly from the issuing company at a specified price. The key words here are “from the issuing company.” The shares set aside for Berkshire Hathaway’s warrant would be dilutive to existing Bank of America common stockholders if the contract were exercised…

As stated above, the preferred stock purchased by Berkshire Hathaway is cumulative. This means that if a dividend is not paid, the balance accrues until Buffett’s company is paid for all past due dividends. All of Bank of America’s publicly traded stock is non-cumulative. If a dividend is not authorized for a certain period, no balance accrues. The preferred shareholders simply do not receive a dividend for that period.”

 

 

Preferred shares are a good security to be knowledgeable about and keep a watchful eye on. In times of big market declines when preferred share price’s drop well below par and companies are less likely to call them up, preferred shares can be a great pickup. This was also noted by Graham:

“Experience teaches that the time to buy preferred stocks is when their price is unduly depressed by temporary adversity. (At such times they may be well suited to the aggressive investor but too unconventional for the defensive investor.)

In other words, they should be bought on a bargain basis or not at all.”

 

Investors in preferred shares today should tread carefully. Most preferred shares are trading well above par value as investors pile into anything with a yield. Preferred shares are also being called away at a faster pace now that banks can afford to borrow much cheaper.  For now, keep patient and learn more about preferred shares if this has spiked your interest. Keep a watch list of specific preferred shares or these ETFs above and watch their prices. There will be a time when fear returns to the market and these securities will be able to be purchased much cheaper.