Preferred Stock ETFs: Beware the Heavy Concentration in Financials

Includes: PFF, PGF, PGX, PSK, XLF
by: Eric Parnell, CFA

This post is the latest in an ongoing series introduced in the article Best Post-QE2 Opportunities Lie Beyond Stocks providing a detailed analysis on investment strategies outside of the stock market leading up to the end of QE2.

Preferred stocks are a tempting option for those investing for income. In an environment where savings rates are near zero and attractive yields are hard to come by, preferred stocks offer plump dividends that run north of 6.0% on average from companies that in many cases have investment grade credit ratings. And preferred stocks provide the added appeal of taking one step up the capital structure from the bottom rung of common stocks. This provides a degree of principal protection in the event of bankruptcy. Because of these advantages, investors may be inclined to consider adding a preferred stock ETF to their portfolio strategy. But because of the composition of the preferred stock universe, investors may be better served by bypassing ETFs and focusing on individual preferred stocks instead.

The primary issue with the preferred stock universe is that it is very heavily weighted to financials. A look at the composition of three of the largest preferred stock ETFs show just how heavily this segment is biased to financials:

  • iShares S&P U.S. Preferred Stock Index Fund (NYSEARCA:PFF) – 84.88% Financials
  • PowerShares Preferred Portfolio (NYSEARCA:PGX) – 87.65% Financials
  • SPDR Wells Fargo Preferred Stock ETF (NYSEARCA:PSK) – 82.98% Financials

As a result of this concentration, the performance of the preferred stock universe ends up being closely tied to that of the financial sector. And during the crisis several years ago, this close correlation resulted in an extreme level of volatility that stretched well beyond the comfort level of the typical income investor.

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During the financial crisis, the preferred stock market declined by over -65% until finally bottoming in March 2009. Although preferred stocks have recovered their value in the few years since, this return trip, uncomfortably, took well over a year. And even in the aftermath of this experience, it is reasonable to wonder how quickly this recovery in preferred stocks would have actually happened without the unprecedented level of support provided by the U.S. government and the Federal Reserve to the financial sector in the wake of the crisis.

With these thoughts in mind, looking forward, the threat of another contagion destabilizing the financial sector still exists as a meaningful risk. One current circumstance centers on the unfolding situation in Greece and the euro zone. Depending on how this situation plays out, it could potentially result in unexpectedly negative shocks for the European banking system that could quickly spread globally a la Lehman Brothers in 2008. Such looming risks warrant caution against taking on undue exposure to the financial sector at this time.

Fortunately, the preferred stock universe still offers attractive opportunities for investors. Unlike bonds, preferred stocks trade on the major exchanges just like common stocks. As a result, investors can readily dissect the preferred stock universe and select individual offerings for their portfolio that offer highly attractive yields with principal stability and largely avoid the financial sector risks discussed above.

In my next post on the topic, I will be presenting five individual preferred stocks that are particularly attractive for a portfolio based on a variety of criteria.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Disclaimer: This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.