Preferred Stock ETFs Still Attractive

On Thursday, State Street launched the SPDR Wells Fargo Preferred Stock ETF (PSK), an ETF that invests in non-convertible preferred stocks. The new SPDR will compete with two existing products from iShares and PowerShares, both of which have been incredibly popular among investors through the first three quarters of 2009.

Preferred stocks are an attractive investment option for several reasons. They feature the regular distributions of fixed income investments, but allow investors to participate in upward price movements in a company’s share price, making them a hybrid of stocks and bonds. Preferred stockholders generally have priority over common shareholders in bankruptcy proceedings, although they must line up behind a company’s debtholders.

While the three preferred stock ETFs now on the market offer exposure to a similar group of securities, they are not identical by any stretch. With approximately 160 underlying holdings, PSK invests in significantly more securities than either PGX (67) or PFF (90).PSK and PGX limit their holdings to securities rated at least investment grade, while PFF invests in several issues rated below BBB- (speculative-rated preferred issues account for nearly 30% of PFF’s assets, likely responsible for a large portion of the YTD return gap relative to PGX). PSK also limits its holdings to non-convertible securities, a restriction not listed in the prospectus for either PGX or PFF.

Regardless of their nuances, all preferred stock ETFs have been very popular in 2009 as investors look for ways to gain exposure to lower risk equities. PGX and PFF have combined cash inflows of more than $1.3 billion through the first eight months of the year, and now have a combined market cap of nearly $3.4 billion.

PowerShares also offers a Financial Preferred Portfolio (PGF) that invests in preferred stocks of financial institutions in the U.S. PGF includes approximately 30 underlying holdings from companies like Bank of America, Barclays, and Wells Fargo, and is up more than 18% in 2009.

The potential for expansion in the preferred stock ETF space remains even after the launch of PSK. Similar to corporate bond ETFs, we are yet to see the introduction of more targeted ETFs (with the exception of PGF) offering exposure to specific maturities, sectors, and credit qualities.

As ETFs continue to catch on, particularly among fixed income investors, don’t be surprised if we see more preferred stock funds hitting the market.

Disclosure: No positions at time of writing.

Comments

[Doug K. Le ...:]

There are three primary rules that govern the market price behavior of an individual preferred stock over its five-year life span (IPO date to call date). By taking advantage of these rules a preferred stock investor can buy and sell in a manner that adds a downstream capital gain to the impressive dividend income that preferreds can provide, essentially doubling the effective return to the investor.

But that’s with individual preferred stocks, not with a preferred stock ETF.

For example, a preferred stock that is closer to its ex-dividend date has more value than a preferred stock that is further away from its ex-dividend date. Therefore, as the ex-dividend date for an individual preferred stock approaches there tends to be more upward pressure on its market price. Buyers can take advantage of this behavior by purchasing individual preferred stocks at a lower price near the beginning of their dividend quarter, thus improving their future capital gain opportunity.

By combining multiple preferred stocks, all of which have widely varying dividend payment schedules, into a single ETF, this aspect of the market price behavior of preferred stocks is lost. While individual preferred stocks, when purchased separately, will follow the three primary rules of market price behavior, a large collection of widely varying preferred stocks, when purchased collectively, will not.

While you correctly point out that investing in a preferred stock ETF is a dividend play, much of your article regards the impressive unrealized capital gains that preferred stocks have experienced this year. These gains are purely a one-time recovery from the credit crisis as cash has come back into the market, beginning with the lowest risk alternatives – bonds and high quality preferred stocks. Readers should not be left with the impression that this year’s gains are due to any organic behavior of the funds themselves that they can look for going forward.

Combining multiple preferred stocks into an ETF eliminates the three primary rules that govern the market price behavior of preferred stocks. Investors looking to add a downstream capital gain to their preferred dividend income, effectively doubling their returns, can do so by building their own preferred stock portfolio with individual preferred stocks bought and sold in accordance with the three rules. Doing so with an ETF relies on exceptional events (such as a global credit crisis recovery) rather than any kind of research-based investment strategy.

Many Happy Returns,
Doug K. Le Du, author of Preferred Stock Investing
PreferredStockInvestin...
PreferredStockInvestin...

Sep 21 01:00 PM

[John K:]

Thank you for pointing out that capital gains are not necessarily part of the return. Some players "roll" dividends by actively trading the preferred stock as soon as it goes ex, and buying another that may go ex in 6 to 8 weeks. If you are very nimble, sometimes you can earn 5 or 5 1/2 dividends a year. That assumes, of course, tight bid/ask spreads.

Sep 21 03:37 PM

[d_teller:]

Doug K. Le Du's note above is right on. One only has to look at PFF's price at ca. $15/share in early March to see how the "interest" or dividend on the initial purchase price looks astronomical.

Sep 21 11:01 PM