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Exchange Traded Funds (ETFs) offer convenience to investors since buying a share of an ETF provides you with a position in each of the securities that the ETF is composed of in one shot.

But for many preferred stock investors that convenience may not be worth the downside, a downside that is specific to ETFs as Wall Street has applied that model to preferred stocks.

Preferred stock investors who build their own portfolio of individually selected high quality[1] preferred stocks take less investment risk, achieve far greater portfolio diversification and realize greater principal protection than those who invest in preferred stock ETFs.

Further, the primary objective of those managing preferred stock ETFs is frequently inconsistent with that of many preferred stock investors.

Preferred Stock ETFs

ETFs are managed such that the market prices of the securities within the ETF follow the movement of a particular index. Investors cannot invest in an index, but they can buy a share of an ETF that attempts to follow the movement of that index.

Those managing the ETF buy and sell shares of the underlying securities accordingly.

These indexes tend to be industry or commodity specific. Standard & Poor's Technology Select Sector Index, for example, reflects the movements in the market prices of various technology related stocks. Investors wanting to invest in the technology industry as reflected by S&P's index can buy shares of the SPDR Technology Section ETF (XLK).

Until May 2011 there were four preferred stock ETFs:

1. iShares U.S. Preferred Stock ETF (PFF). This is the most popular preferred stock ETF and attempts to reflect the U.S. Preferred Stock Index as published by Standard & Poor's;

2. PowerShares Financial Preferred ETF (PGF). Pegged to the Hybrid and Preferred Securities Financial Index from Wells Fargo. Positions are limited to banks;

3. PowerShares Preferred Portfolio ETF (PGX). Based on the BofA Merrill Lynch Core Fixed Rate Preferred Securities Index and includes only investment grade securities; and

4. SPDR Wells Fargo Preferred Stock ETF (PSK). Follows the Wells Fargo Hybrid and Preferred Securities Aggregate Index. Substantial positions in European banks.

Diversification

These preferred stock ETFs have a heavy concentration in trust preferred stocks (TRUPS) issued by U.S. banks. That lack of diversification is creating an increasing problem for these preferred stock ETFs since most TRUPS issued by our Big Banks are likely to be retired over the next couple of years in response to section 171 of the Wall Street Reform Act (signed into law in July 2010).

Not coincidentally, in May 2011 Global X introduced their Canadian Preferred ETF (CNPF) based on Canadian preferreds trading on the Toronto Exchange followed in November 2011 by the iShares S&P International Preferred Stock Fund (IPFF) which is composed primarily of Canadian bank preferred stocks and competes with CNPF.

Investment Risk

With the exception of PGX, these preferred stock ETFs include a substantial exposure to speculative grade preferred stocks (ratings of CNPF holdings were not provided). Remember, the objective of the fund manager is for the market price of the ETF to mimic the movement of the targeted index. Including shares of speculative grade securities, which tend to have different price dynamics than investment grade preferreds, is a common tool used to help meet that objective.

While including speculative grade securities provides the fund manager with a valuable index-matching tool, doing so exposes the preferred stock investor to investment risk that those building their own portfolio of individually selected preferred stocks would probably avoid. High quality preferred stocks are providing an average annual dividend yield of 7% right now.

The post-Lehman recovery period provides an excellent study period to see the effect that speculative grade preferred stocks have on the price dynamics of a preferred stock ETF.

The following chart compares the price performance of these two very different preferred stock investing strategies between September 2008 (Lehman bankruptcy) and December 2009 (recovery). The blue line shows the market price change[2] of a portfolio of high quality preferred stocks while the black line illustrates the change in the market price of iShares PFF, the most popular preferred stock EFT.

A portfolio of high quality preferred stocks fell far less than shares of the iShares PFF ETF at the bottom (-17% compared to -33%) and gained much more ground when the market recovered (+39% compared to +20%).

That’s about half the downside and twice the upside by building your own portfolio of the highest quality preferred stocks rather than taking on the exposure to speculative grade securities.

Preferred stock investors who build their own portfolio of individually selected preferred stocks have more control over their holdings and the risk profile that those holdings represent.

A Misalignment Of Objectives

Preferred stock investors who build their own portfolio of individually selected preferred stocks select specific preferred stocks that are consistent with their objective of maximizing dividend income while minimizing risk.

This objective is fairly easy to attain, but it does require a certain amount of diligence over a period of time in order to build a low risk dividend-generating engine.

Preferred stock investors are risk-averse, buy-and-hold investors seeking stable dividend income over the long-term. Preferred stock dividends are paid based entirely on the number of shares owned by the investor; the current market price is not part of the equation nor is your original purchase price.

For this reason, preferred stock investors are not as sensitive to market price fluctuations as common stock investors.

But maximizing dividend income while minimizing risk is not the objective of those managing a preferred stock ETF.

The objective of those managing a preferred stock ETF is to match the movement of an index that is pegged to market prices. They buy and sell shares of the underlying preferreds such that the share price of the ETF does so. Like all ETFs, but unlike preferred stock investors, those managing preferred stock ETFs are focused on market price fluctuation as reflected by the targeted index.

Preferred stock investing is all about maximum dividends at minimum risk whereas preferred stock ETF management is all about managing price movement to match an index.

Those are two very different objectives.

Principal Protection

There are a variety of techniques available for preferred stock investors to pile a capital gain on top of the respectable dividend income that high quality preferred stocks provide. Doing so can add a layer of principal protection to your holdings. One such technique takes advantage of the "time value of money."

In short, the time value of money says that a preferred stock that is closer to its dividend pay day (ex-dividend date) will take on more value (i.e. a higher market price) than an otherwise identical preferred stock that is further away.

In other words, there tends to be more upward pressure on the market price of a preferred stock later in its dividend quarter and less upward pressure in the earlier days.

As you might guess, taking advantage of this effect when buying or selling your preferred stock shares helps to protect your principal. If the price rises well beyond the upcoming dividend amount just prior to the ex-dividend date, many preferred stock investors would consider selling.

The series P preferred stock from Public Storage (PSA) offers a good example. The market price of PSA.PP[3], which pays a quarterly dividend of $0.41 per share, increased throughout the last quarter of 2010 by $1.17. Those who sold their shares pocketed almost three quarters worth of income in one shot without having to wait another six months.

But for those investing in a preferred stock ETF, this key price behavior is eliminated. The preferred stocks that make up preferred stock ETFs have varying dividend payment schedules. Some are in the early days of a dividend period when prices tend to be lower while others will be approaching their ex-dividend dates when upward price pressure is highest. Consequently, those investing in a preferred stock ETF lose the ability to use the time value of money to their advantage when buying or selling shares and the principal protection benefit that comes with doing so.

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The ETF model was invented to provide investors with an easy way to invest in an industry or commodity market without having to buy individual securities (while providing visibility to real-time pricing). Such ETFs are tuned to follow the movement of an index that is pegged to the market price behavior of the common stocks or commodity prices that the index reflects. Such ETFs offer diversification and convenience to the investor.

Preferred stock ETFs, however, represent an effort by Wall Street to apply a model designed for industry and commodity market investing to a type of equity security. Preferred stocks are neither an industry nor a commodity and, not surprisingly, the ETF model, as applied to preferred securities, can expose preferred stock investors to a downside that is not always obvious.

While preferred stock ETFs may appeal to investors who hold convenience as a primary objective, it is not clear that the convenience offfered by preferred stock ETFs is greater than the benefits of creating your own high quality preferred stock portfolio from individually selected issues.

Footnotes:

(1) High quality preferred stocks are those that meet the ten risk-lowering selection criteria from chapter 7 of my book, Preferred Stock Investing. For example, high quality preferred stocks (a) offer "cumulative" dividends (if the issuing company skips a dividend payment to you they still owe you the money; their obligation to you accumulates), (b) are rated as investment grade and (c) are issued by a company that has a perfect track record of never having suspended a preferred stock dividend. For more about how to select, buy and sell the highest quality preferred stock read my October 24, 2011 Seeking Alpha article titled "Preferred Stock Investing: A Simple Guide To 7% Yield".

(2) I have researched and published a variety of preferred stock market price data since January 2001. Price data seen here for high quality preferred stocks is calculated from the average monthly market price of such securities as published to subscribers of the CDx3 Notificaiton Service (my preferred stock email alert and research newsletter service) with the monthly "Perfect Market Index." The Perfect Market Index illustrates the type, direction, speed and magnitude of changes in the marketplace for high quality preferred stocks.

(3) To look up the market price of PSA.PP, click here to go to Seeking Alpha's Preferred Stock Trading Symbol Cross-Reference Table to see how your online service denotes preferred stock trading symbols.

Source: Preferred Stock ETFs: The Downside That Preferred Stock Investors Can Avoid