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Preferred stocks can be correctly described as hybrid instruments which possess the qualities of both stocks and bonds. Like stocks, they are part of the issuing company’s equity and have a dividend yield. Unlike stocks, the dividend yield is fixed and the instrument is rated by rating agencies. Practically 90% of all preferred equity is issued by financial companies with the rest being issued by utilities and telecom companies. The ETFs that invest in preferred equity or track a preferred stock index are called preferred/convertible ETFs.

In current scenario, U.S. preferred/convertible ETFs are an important aspect of most long-term investment portfolios like IRA investments, 401K investments and other retirement investment accounts. The main reason for this preference is that U.S. preferred stocks tend to yield over 6% which is much higher than other debt asset classes like intermediate treasuries or corporate bonds.

Let us take a closer look at the performance of U.S. preferred/convertible ETFs vis-à-vis other high dividend ETFs.

Dividend Stock ETF Trend

11/17/2011

Performance data are based on closing prices on last Wednesday

Description

Symbol

1 Week

4 Weeks

13 Weeks

26 Weeks

52 Weeks

Trend Score

PowerShares HighYield Dividend Achievers

PEY

-0.58%

1.37%

11.55%

-1.06%

7.91%

3.84%

Vanguard High Dividend Yield Indx

VYM

-1.31%

0.37%

7.9%

-4.82%

10.54%

2.54%

SPDR S&P Dividend

SDY

-0.79%

1.45%

9.61%

-4.03%

6.39%

2.52%

iShares Dow Jones U.S. Real Estate

IYR

-1.37%

2.61%

1.28%

-10.38%

6.4%

-0.29%

iShares S&P U.S. Preferred Stock Index

PFF

-0.55%

0.56%

0.41%

-6.22%

-1.38%

-1.44%

PowerShares Intl Dividend Achievers

PID

-1.82%

-1.82%

0.25%

-10.51%

-1.01%

-2.98%

WisdomTree Emerging Market Equity Income

DEM

-1.74%

2.18%

-3.16%

-14.51%

-6.85%

-4.82%

For more on the comparative performance of various asset classes, see here

As we can see, U.S. preferred ETFs have underperformed most high yielding equity dividend ETFs thanks to the 3 year rally in the S&P500. At the same time, they have bettered most international and emerging market dividend ETFs.

Let us now examine some of the U.S. preferred/convertible ETFs that trade currently.

U.S. Preferred/Convertible

11/18/2011

Description

Symbol

1 Yr

3 Yr

5 Yr

Avg. Volume(K)

1 Yr Sharpe

PowerShares Preferred

PGX

3.89%

14.96%

NA

467

65.07%

SPDR Wells Fargo Preferred Stk

PSK

0.67%

NA

NA

16

9.48%

PowerShares Financial Preferre

PGF

-0.65%

20.6%

NA

421

-6.73%

iShares S&P U.S. Preferred Stk

PFF

-1.22%

20.47%

NA

1,383

-14.03%

SPDR Barclays Capital Convertible

CWB

-3.81%

NA

NA

207

-28.36%

For more information on ETFs linked to different asset classes, see here

As shown in the table, PFF is the most liquid ETF in this category with a daily average volume of 1,383K. PFF also tracks the most prominent U.S. preferred stock index - the iShares S&P U.S. Preferred Stock Index. However, PGX has the best 1-yr return (3.89%) and the highest Sharpe ratio (65.07%) along with decent liquidity (467K daily average volume). So let us consider PGX for starters.

For more on PGX’s core holdings and credit quality, check the tables given below

Top 10 Holdings (46.22% of Total Assets)

Company

% Assets

Barclays Bk

6.16

Wells Fargo & Co, San Francisco Ca Pfd

5.21

JP Mgn 7% TRUPS32-J

4.82

Citigroup Cap Xiii Pfd

4.71

Barclays Bk Pfd

4.54

HSBC 8% PSCS-2

4.21

Wells Farg 7% CS 31

4.19

Jpmorgan Chase Pfd

4.15

Citigroup Cap Xii Pfd

3.99

Bond Ratings (%)

Sector

PGX

US GOVERNMENT

N/A

AAA

0.00

AA

2.96

A

23.78

BBB

46.90

BB

16.36

B

0.00

BELOW B

0.00

OTHER

10.00

As with other preferred stock ETFs, PGX’s core holding consists almost entirely of preferred equity issued by large banks and financial institutions like Barclays bank, HSBC, Wells Fargo, Citigroup etc. In all, the share of financials in PGX’s portfolio comes to an astounding 98%. Moving on, when we take a look at PGX’s credit rating we find that over 73% is BBB rated and higher which makes it reasonably safe unless we see another debt crisis or growth contraction in the U.S. economy.

Looking at the facts discussed above, one may consider U.S.preferred/convertible ETFs like PGX to be good candidates for asset allocation to long term investment portfolios. However, we must point out that once the Basel 3 rules come into effect after 2013, preferred stock will no longer count as Tier 1 capital for backs. Since banks and financial institutions account for almost 90% of preferred stock issuance, the new rules are expected to irrevocably alter the future of preferred stocks as an asset class. Thus, it is advisable to limit or avoid U.S. preferred stock ETFs till there is more clarity on the new rules and the type of security that may replace preferred stocks post Basel 3.

Disclaimer: MyPlanIQ does not have any business relationship with the company or companies mentioned in this article. It does not set up their retirement plans. The performance data of portfolios mentioned above are obtained through historical simulation and are hypothetical

Source: U.S. Preferred/Convertible ETFs: An Uncertain Future