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Preferred stocks are often overlooked by investors seeking yield and income. However, this class of assets generally offers higher yield and less risk than their related common stocks. The downside, of course, is that preferred stocks may offer less opportunity for capital gains. This article will investigate preferred stock ETFs and Closed End Funds (CEFs) with the goal of constructing a high return lower risk portfolio.

With investors showing increased interest in yield, a number of new preferred ETFs and CEFs have been offered over the last few years but I will limit my investigation to ETFs and CEFs that have a track record of at least 3 years. I considered three preferred ETFs:

PFF: iShares US Preferred ETF. This is the most liquid ETF with a daily volume more than 1.5 million shares. It has 288 holdings selected primarily from securities that are part of the S&P U.S. Preferred Stock Index. Holdings focus on the bank, real estate, and insurance sectors. The current yield about 6%.

PGX: Powershares Preferred Portfolio. Eighty percent of the holdings in PGX are from the B of A Merrill Lynch Core Plus Fixed Rate Preferred Securities Index. It holds 177 securities mainly from the financial sector. It is also very liquid, trading about a million shares per day. The current yield is about 6.4%.

PSK: SPDR Wells Fargo Preferred Stock ETF. This ETF is based on the Wells Fargo Hybrid and Preferred Securities Aggregate Index. It has 137 holding, primarily from the financial sector. This ETF is not as liquid as PFF or PGX and trades only about 80K shares per day. The current yield is 6.25%.

Using the Smartfolio 3 program (www.smartfolio.com), I analyzed these ETFs in more detail. Figure 1 shows the annualized rate of return in excess of the risk free rate of return (called Excess Mu on the charts) plotted against the historical volatility. SPY is also shown for reference. As you would expect, over the past three years, these preferred stock ETFs were less volatile than the S&P 500 but also offered a lesser rate of return. Figure 2 provides the associated correlation matrix. These ETFs have only a 50% to 60% correlation with SPY but they are highly correlated among themselves. Using more than one of these ETFs provides virtually no diversification.

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Figure 1: Risk Reward for Preferred Stock ETFs

Figure 2: Correlation Matrix for Preferred Stock ETFS

To gain more diversification, I expanded my search criteria to consider Closed End Funds (CEFs). There are about 15 preferred stock CEFs but many are now priced at a premium (due to yield hungry investors bidding up the price). Since CEFs typically use leverage, they can offer a higher yield than their more conservative ETF cousins. I do not like to pay premiums so I limited my search to CEFs that sell at a premium less than 1% (or sell at a discount). I also required at least 3 years of history. The following CEFs survived by filter:

HPS: JH Preferred Income III. This CEF sells at a premium just below 1% and has a 7.5% annual distribution rate that is paid monthly. The discount/premium has ranged from minus 5% to plus 6% over the last year. It is actively managed with 107 preferred securities that are chosen from global companies. About 60% of the holdings are from the financial sector and but 23% are preferred stocks of utility companies. At least 65% of the preferred stocks are investment grade and the fund employs about 33% leverage. HPS is relatively liquid for a CEF, trading about 70K shares per day. However, I would recommend always using limit orders to buy or sell.

JPC: Nuveen Preferred Income Opportunity. This CEF sells at a 4% discount and has an annual distribution rate of 7.5% paid monthly. Over the last year, the discount has been as low as minus10% and as high as plus1%. The fund has more than 200 holdings, primarily in the insurance, commercial bank, real estate, and financial services sectors. At least 60% of the holdings are investment grade and it employs 28% leverage. It has excellent liquidity for a CEF, trading over 200K shares per day.

JTP: Nuveen Quality Preferred. This CEF sells at a 2% discount and has an annual distribution rate of 6.7% that is paid monthly. The discount/premium has ranged from minus 9% to plus 2% over the last year. It holds about 190 securities, of which 55% are from the U.S. It invests predominantly in investment grade securities in the insurance, banking, real estate, and financial services sectors. It employs leverage of about 28%. This CEF is also liquid, trading over 150K shares per day.

PDT: JH Premium Dividend Fund. This CEF sells at a discount of 4% and has an annual distribution rate of 6.4% paid monthly. Over the last year, this CEF has sold between a discount of 9% and a premium of 7%. In addition to preferred stocks (65%), this fund also invests in high dividend equity. If has a little over 100 holdings, all from U.S. companies and employs about 33% leverage. This CEF invests primarily in the utilities and financial sectors. It is relatively liquid, trading over 100K shares per day.

Figure 3 shows these CEFs plotted on the risk reward plane. As expected, the CEFs have a higher rate of return than the ETFs and also more risk. However, it is a little surprising that the CEFs had a better return than SPY over the past three years. This is likely due to the fact that preferred stocks were devastated in 2008 along with most other asset classes. The last three years have been an excellent environment for CEFs, especially those investing in high return assets. By employing leverage in a favorable environment, these CEFs have risen even more rapidly than the S&P 500 (and with less volatility!).

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Figure 3: Risk Reward for Preferred Stock Portfolio

Figure 3 includes the overall portfolio statistics when the CEFs are combined with PGX. These statistics were computed via Smartfolio 3 using historical data in a one factor model. The resulting portfolio is very interesting. It currently has a healthy 6.8% yield and over the past three years, the portfolio has delivered a 14% larger gain than the S&P 500 with a 30% less volatility!

This is an illustration of Modern Portfolio Theory (MPT) in action. By combining higher risks assets with lower risk assets, you can potentially reduce the overall risk of your investments while maintaining the gains. One of the keys to achieving this is to combine assets that relatively uncorrelated with one another.

Figure 4 provides the correlation matrix for this portfolio. The CEFs and the ETF are not highly correlated with each other (only about 50% to 60%). Therefore, when we combine these assets together in an equally weighted portfolio, we obtain the benefits of MPT.

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Figure 4: Correlation matrix for Preferred Stock Portfolio

Of course, this result is based on the last three years, which were wonderful years for stock investors. No one knows if this trend will continue but for the time being at least, I accomplished my goal of constructing a high return lower risk portfolio using preferred stocks.

Source: A High-Return, Lower-Volatility Portfolio