The first wave of growth in the ETF industry came as investors embraced the exchange-traded structure as an improvement over traditional actively managed mutual funds–a more cost-efficient and tax-friendly way to access traditional asset classes such as stocks and bonds. But in recent years much of the growth in ETF assets has been attributable to “democratizing” products that bring previously hard-to-reach or inefficient asset classes within reach.
Commodities are the most obvious example, as all types of investors have flocked to both physically-backed precious metals ETFs and futures-based funds targeting everything from cotton to sugar. Preferred stocks were never quite as difficult to access as gold bars or corn futures for most investors, but this hybrid asset class hasn’t exactly been a regular component of typical retirement portfolios.
Preferred stock ETFs have seen remarkable success in recent years. At the end of March 2009, the five Preferred Stock ETFs trading in the U.S. had aggregate assets of about $2.1 billion. Just a year later, that figure stood at more than $7 billion, a tremendous increase attributable to both rising price levels and consistent cash inflows.
Preferred Stock ETFs
Preferred stock is by no means a new type of security, but its availability through an ETF is a relatively new development. Preferred stockholders are generally entitled to a fixed dividend rate that is subordinate to debt but senior to dividends on common stock. So the cash flow from these securities is more risky than interest payments on debt but less risky than dividends on stock. Some preferred stock is convertible into common stock at a predetermined ratio, providing the potential to retain upside in an investment while reducing downside risk.
Two of the most popular options for gaining exposure to preferred stock are the iShares S&P U.S. Preferred Stock Index Fund (PFF) and PowerShares Financial Preferred Portfolio (PGF). While these ETFs will generally be impacted by the same macroeconomic factors–such as interest rates and underlying stock fundamentals–they are far from identical. Below, we compare these popular ETFs in several key areas.
Indexes And Holdings
PFF tracks the performance of the S&P U.S. Preferred Stock Index, a benchmark that includes preferred stocks with a market capitalization over $100 million that meet minimum price and trading volume requirements. PGF is linked to the Wachovia Hybrid & Preferred Securities Financial Index, a benchmark that includes preferred stocks issued by financial institutions that are selected by Wachovia pursuant to a proprietary methodology.
So the biggest difference between PFF and PGF is the sector exposure offered by each. PGF focuses on securities issued by financial firms, while PFF includes preferred stock issued by companies in various industries. But PFF still has a significant concentration in the financial sector; almost 90% of holdings are issued by financial institutions. This tilt towards banks and other financial firms reflects the composition of the universe of preferred stock issuers. Because certain types of preferred stock may be included as Tier 1 capital when calculating capital adequacy ratios, banks are among the most common issuers of preferred stock.
PowerShares also offers a “diversified” preferred stock ETF; the Preferred Portfolio (PGX) gives a weighting of about 85% to the financial sector.
Risk And Return
Similar to debt, certain preferred stock issues are given a quality rating by agencies such as S&P and Moody’s based on the perceived ability of the issuer to make good on their obligation to preferred shareholders. Because preferred stock dividends are subordinated to debt payments, preferred stock will generally maintain a credit rating at least two “notches” below debt issued by the same company.
From a credit quality perspective, PFF and PGF are pretty similar. Both funds are concentrated most heavily in securities with an S&P credit rating between “B” and “BBB.”
Both ETFs offer relatively attractive current returns. As of April 20, PGF’s 30-Day SEC Yield was an impressive 7.6%; as of March 31 PFF’s 30-Day SEC Yield stood at 6.42%. Preferred stock ETFs have been among the best performers over the last year, thanks in large part to their significant allocation to the financial sector, which has rebounded nicely since the bear market lows. Through the first quarter of 2010, PFF had a one year return of over 85%. PGF’s pure play exposure to financials put it ahead of even that impressive mark; the PowerShares ETF was up just over 100% in the same period.
The edge in expenses goes to PFF, which charges an annual fee of 0.48%. PGF’s expense ratio is 0.60%.
Both PFF and PGF offer efficient ways to add preferred stock exposure to any investor portfolio. For those looking for bit of diversification across sectors, PFF may be the better play (although any diversification benefits will be limited by the significant allocation to financials). PFF could also be the better choice for those looking to minimize expenses or gain greater depth of holdings, as it has almost twice the number of components as PGF. But for those looking to make a pure play on financial preferred stocks (the potential rewards of which are reflected in the relative returns over the past year), PGF might be the way to go.
Disclosure: No positions at time of writing.
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