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The world thrives on innovation. With the growth and advent of technology, each day marks new developments and creates something useful for mankind. Talking about innovation and development, the financial world is also not left behind by any means. With time, lots of investment opportunities are being created, domestically as well as globally, for the investors to earn maximum returns by parking their hard earned money.

In today’s world, the investors have a wealth of choices with so many investment avenues available to them. While some “innovative” financial instruments are viewed as “weapons of mass destruction”, most of the innovations in the financial sphere have helped investors realize their investment objectives in the longer run.

Therefore, knowledge about your investments—and the number of other choices out there-- is of utmost importance. As a result, we would like to touch upon Preferred Stocks as an asset class which has been in existence for a long time, but has often been ignored by investors due to lack of knowledge about the inner workings of this interesting slice of the market (see Van Eck Files For Preferred Security and Global Chemicals ETFs)

Features of Preferred Stocks

Preferred securities as an asset class are hybrid securities, having traits of both equity shares as well as fixed income securities. They are classified as shares having a fixed rate of dividend on their face value (par value) (see Russell Launches Two New Dividend ETFs). These types of shares generally get preference over equity shares in terms of both dividend payments as well as at the time of liquidation should the firm go belly-up.  

However, bondholders are considered to be creditors of the issuing company and get their share of interest and capital payments prior to the preferred stockholders. Like fixed income securities, preferred stocks also are credit rated based on the past track record of the issuing company and usually carry no voting rights.

Investing in Preferred Stocks has its own pros and cons. While the priority over dividend and capital repayments over common stocks might seem a lucrative scenario, it also involves certain risks. These instruments are sensitive to interest rate movements and have an inverse relationship with them just like bonds. However, the rate of change of preferred stock price with respect to changes in interest rates is much less volatile than their fixed income counterparts (read Three Financial ETFs Outperforming XLF).

Some preferred stocks are also convertible in nature (i.e. can be converted to equity shares after a given time). The prices of such preferred stocks are also dependent on the equity shares of the issuing company. A price appreciation in the common stocks usually results in a price appreciation for the preferred stocks as well. Therefore, these financial instruments also involve market risks as well.

Preferred Stocks usually do not have a fixed maturity, however, most of the stocks are callable. This feature enables the issuing company to redeem the stocks from the open market, at a given point in time. The issuing company can also take strategic advantage of raising finance through preferred stocks, as it can defer dividend payment in a particular year without its credit rating being affected.

This trait of preference shares exposes them to a risk of non-payment of dividends if during any financial year the issuing company is facing cash crunch. Therefore it is very important to select those preferred stocks that have good credit rating issued by great companies that have a solid track record.

ETF approach to preferred stock investing

Three major factors that need to be addressed while analyzing preferred stocks are 1) Liquidity of the preferred stocks (i.e. volume of trade), 2) Credit Quality and 3) Performance of the issuing company’s equity shares in the stock market. The hybrid nature of preferred stocks gives it traits of both equity shares as well as debt securities and their performance largely depends on the interest rate movements as well as fundamental performance of the issuing company in the stock markets.

This makes it very difficult for the layman investor to understand and analyze them and more often they end up making wrong choices. However, investing in Preferred Stock ETF solve this problem for the common investor of carefully hand picking preferred stocks that have good credit ratings, higher liquidity, and securities issued by fundamentally strong companies, mainly thanks to their basket approach of investing and expertise pertaining to this particular asset class.

In the U.S., publicly listed preferred stock are generally issued by a select few institutions including; REITs and public utilities. Banks and financial institutions have the liberty to raise preferred stocks in order to strengthen their Tier-I capital due to regulatory requirements (read ETF Trading Report: Growth and Banking ETFs In Focus).  It is therefore reasonable to assume that the performance of the Preferred Stock ETFs will largely depend on the performance of the financial sector as a whole.

On the equity front in fiscal year 2012 the financial sector has been one of the best performing sectors in the U.S equity markets outpacing many of its counterparts. However, the 52 week data shows that the sector was one of the worst performing segments, mainly thanks to the European debt crisis and the downgrading of the U.S sovereign credit rating, by rating agency Standard & Poor (S&P).

These events increased the borrowing costs for various banks and financial institutions across the U.S, resulting in squeezed margins, thereby leading to a dismal performance by the financial sector as a whole (read Beware These Three Volatile Financial ETFs).

Many popular financial ETFs tracking the broader markers like Vanguard Financials ETF (VFH) and iShares Dow Jones US Financial Sector ETF (IYF), also suffered during this period (late July till December 2011) fetching negative 52 week returns for investors.

However, with favorable economic data coming in domestically and globally, the financial sector has already entered a strong recovery phase and these financial ETFs have already witnessed an uptrend from the start of fiscal year 2012.

On the debt front, it is prudent to note that presently we are still in a low interest rate environment as suggested by the Ten Year yield and its level around the 2% mark. This provides a great opportunity to invest in preferred stock as these securities can pay out yields far higher than their fixed income counterparts while still participating in equity appreciation as well.

Therefore we see that from the equity front as well as debt front investing in preferred stocks presently seems attractive. Below we share with you some ETFs that should be considered by an investor looking for exposure in the Preferred Stock ETF space:

SPDR Wells Fargo Preferred Stock (PSK)

Launched in September 2009, PSK tracks the pre expenses price and yield performance of Wells Fargo Hybrid and Preferred Securities Aggregate Index. The Index is a modified market capitalization weighted index composed of preferred stock.

The fund employs a replication strategy holding at least 80%, of total assets in the securities comprising the index. The ETF holds 163 securities in all of which 147 are preferred stock holdings. The rest are either common stocks or bond holdings (see more on ETFs at the Zacks ETF Center).

The ETF does well in eliminating concentration risk as it holds a mere 17.13% of its total assets in its top 10 holdings. The fund has also seen good inflows in its asset base since its inception and charges only 45 basis points in fees and expenses which is among the lowest in this category. The ETF pays out a solid yield of 6.39%, therefore it should be considered by investors seeking high levels of current income.

PowerShares Preferred ETF (PGX)

This ETF tracks the BofA Merrill Lynch Core Plus Fixed Rate Preferred Securities Index which is a capitalization-weighted benchmark designed to reflect the total return performance of the U.S. dollar-denominated preferred securities market. The fund has returned 6.97% in the past one year which is one of the highest in the preferred stock ETF space.

The fund holds 123 securities in total and puts 36% of its total assets in the top 10 companies. Heavyweights like Wells Fargo, Citigroup, Barclays Bank PLC etc form a major part of its portfolio. The fund charges 50 basis points in fees and expenses compared to a category average of 0.49%. The ETF is very popular as suggested by its total assets of $1.60 billion which have been amassed since inception in early 2008.

PowerShares Financial Preferred ETF (PGF)

This product tracks the Wells Fargo Hybrid & Preferred Securities Financial Index which is a capitalization weighted index tracking the performance of preferred securities issued by financial institutions in the U.S. markets. At any point of time, the fund invests at least 90% of its assets in securities from the underlying index.

It has returned a decent 5.96% in the last one year period charging investors 60 basis points in fees and expenses. The expense ratio of this ETF happens to be on of the highest in the preferred stock ETF space. The fund holds 46 securities presently and allocates 52.95% of its assets in the top 10 holdings. Like most of its counterparts, PGF pays out an impressive yield of 6.83%.

iShares S&P U.S. Preferred Stock ETF (PFF)

PFF is perhaps the biggest and most popular name in the preferred stock ETF space. With total assets of $8.36 billion, it is the largest fund in this category and it is widely traded, producing tight bid ask spreads.

As a result, the ETF enjoys economies of scale and this advantage is passed on to the investors by charging just 48 basis points in fees and an expense, which is a basis point lower than the category average.

The fund has returned 4.47% in the last one year and pays out 6.07% per annum as dividends. The ETF holds 237 securities in all and eliminates concentration risk by allocating a mere 16.83% of its total assets in its top 10 holdings. PFF is perhaps the safest bet for an investor looking to get exposure in the Preferred Stock ETF space.

iShares S&P International Preferred Stock ETF (IPFF)

IPFF is one of the newest additions in the iShares Fund Family. Launched in November of 2011 amidst the European debt crisis, the ETF has done well in managing $94.85 million since its inception.

This confirms the investors’ appetite in this space. IPFF also enjoys brand equity being a part of one of the most esteemed fund family, which explains the massive inflow in its asset base (see iShares Debuts Two High Yield Bond ETFs).

It has generated YTD returns of 4.98%, however, it is on the expensive side charging investors 55 basis points in fees and expenses. It holds 63 securities in all and does well to allocate just 26.26% of its total assets in its top 10 holdings.

The ETF is yet to distribute any capital gains or dividend income. However, given the nature of preferred stock ETFs, it can be guessed that like most of its counterparts, this fund will also be a high yielding ETF.

Global X Canada Preferred ETF (CNPF)

Launched in May of 2011, CNPF tracks, before expenses, the price and yield performance of the Solactive Canada Preferred Index, which tracks the performance of preferred stocks from Canadian issues that trade on the Toronto Stock Exchange.

The ETF has managed to bring in $12.4 million since inception and has returned 1.67% YTD. The fund holds 48 securities in all and allocates 27.90% of its total assets in the top 10 holdings.

The ETF has an expense ratio of 58 basis points which might be considered to be on the higher side given the category average of 0.49%. Like IPFF, this ETF is also yet to distribute dividends and capital gains, but is expected to do so in the near future.

The ETF is a good choice for investors looking for a broad based global exposure in the preferred stock space as it captures the essence of Canadian Preferred stocks, giving a nice international component to preferred stock focused portfolios.

Below is the summarized tabular comparison of the 6 ETFs in the preferred stock ETF space considering the important parameters:

 

ETF Name

Inception

Returns (%) (TTM when available)

Avg. Daily Volume

% of total assets in top 10 holdings

Expense Ratio (%)

No. of holdings

Total Assets

CNPF

May 2011

1.67%

12,855

27.90

0.58

48

$12.4mn

IPFF

Nov 2011

4.98%

49,425

26.26

0.55

63

$94.85mn

PFF

Mar 2007

4.47%

1,382,019

16.83

0.48

237

$8.36bn

PGF

Dec 2006

5.96%

349,330

52.95

0.60

46

$1.60bn

PGX

Jan 2008

6.97%

498,111

36.01

0.50

123

$1.59bn

PSK

Sep 2009

4.82%

31,380

17.13

0.45

163

$192.61mn

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