Examining the Value of Active Management for Preferred Securities Investments

Includes: PFF
by: David Levy

In the current environment where yields on U.S. government securities and on investment grade corporate debt are so paltry, investors are on a constant hunt for yield. One area with yield to consider is preferred securities. Even after large moves off of their 2009 lows, the average yield of preferred securities remains near their 10-year average of 7.4%. The current spread of preferred securities over the 10-year Treasury sits near 425 basis points, well above the average spread of 293 basis points, making an investment in preferred securities appear attractive.

Within the preferred securities space, there are three securities which I primarily consider, and there are reasons to own each of them. They are iShares S&P U.S. Preferred Stock Index (NYSEARCA:PFF), Nuveen Preferred Securities (NPSAX), and Cohen & Steers Preferred Securities & Income (CPXAX). In my opinion, the primary consideration when comparing an investment in an ETF to that in a mutual fund is whether the manager of the mutual fund can justify the higher expense ratio he charges compared to the passively managed and therefore less expensive ETF.

In comparing the three securities above, let’s start by disclosing their expense ratios:

  • iShares S&P U.S. Preferred Stock Index (PFF): 0.48%
  • Cohen & Steers Preferred Securities & Income (CPXAX): 0.85%
  • Nuveen Preferred Securities (NPSAX): 1.12%

As expected, an investment in the iShares is 35 to 60 bps less expensive. So what does an investor gain by paying for the more expensive mutual funds? The answer is twofold.

Mutual funds are run by active managers as opposed to ETFs which are passively benchmarked to an index. This allows the managers of the mutual funds to add value with individual security selection.

As such, you see a much higher concentration in the mutual funds' top 10 holdings. While both the iShares ETF and the Nuveen fund have a similar number of holdings (241 vs. 210), the iShares top 10 holdings account for only 17.5% of the ETF compared to the top 10 holdings of the Nuveen, which comprise nearly 30% of the fund. The Cohen & Steers fund has only 133 holdings, and the top 10 holdings make up 21.3% of the fund.

Obviously, a capable management team is essential to this equation with the increased importance in security selection, and that's where the fund managers of both the Nuveen and Cohen & Steers funds have revealed their value. The chart below (click to enlarge) shows the one year return of all three securities. Over the last year (6/21/10 – 6/20/11), the iShares ETF has returned 13.79% including dividends while the Cohen & Steers fund has returned 18.00% and the Nuveen fund 18.86%.

1 Year Return

If we take a further step back and consider the 3-year return, the value of active management is even more apparent. The Nuveen fund returns 33.15% (10.01% annualized) while the iShares ETF returns 20.41% (6.39% annualized). Note that the inception of the Cohen & Steers fund was not until 2010. The outperformance is clear, especially in periods which encompass a down market.

The other primary factor to consider is risk as measured by volatility. I have gone on record previously with my preference of mutual fund investments over ETF investments in the fixed income asset class. The primary reason is that fixed income ETFs tend to act like closed-end mutual funds during times of market volatility. This means that depending on when you purchase and sell an ETF, you have to consider not only the investment you are making, but also a potential premium or discount being associated with the security.

The worst possible case for an investor is to buy an ETF in a strong market which is trading at a premium and sell it in a weak market when it is trading at a discount. In this instance, your performance will vary, in some cases significantly, from that of the index you are attempting to track. This premium / discount disparity rarely works in the investor’s favor over the short-term, with the exception being when an investor purchases the ETF when it is trading at a discount.

The chart below (click to enlarge) clearly shows the increased volatility in the iShares ETF compared to the mutual funds over the last month. While the performance of the Nuveen fund and the iShares ETF are similar, with both down approximately 1.5%, the ride the Nuveen fund provides has been much smoother. Over the same time period, the Cohen & Steers fund was down only 1%. The 3-year standard deviation for the iShares is 32.32% while the 3-year standard deviation for the Nuveen is 6.4% lower at 25.92% (Cohen & Steers inception is less than 3 years).

1 Month Return

While there are many good reasons to use ETFs, don’t simply consider the annual expense cost when making your purchase. Give consideration to a proven fund manager or before you know it, buying the cheaper fund may end up costing you.

Disclosure: I am long PFF, CPXAX, NPSAX.

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