Before I begin my analysis of my three top picks within preferred closed end funds and ultimately the winner of the Preferred CEF Showdown, I would like to restate what my objective is with this series of analyses (as, unfortunately, it has been a while since my last article in the "showdown" series - the earlier of which can be found here, here and here )
At one point in my career, I worked for an investment consulting firm, where I was the Director of Fixed Income Research. Essentially, what I was responsible for was analyzing markets and managers and recommending managers for our clients' (pensions, endowments, foundations...) fixed income mandates. The analysis and recommendations were based on:
Manager returns, and
Fund/portfolio client fit
This is what I planned for the series: I am going to review three managers' preferred closed end fund complexes (one manager per article) and recommend one fund per manager. All data used in this report is from company reports and filings, CEFA and Morningstar.
The three funds chosen in the showdown are:'
- Flaherty and Crumrine's Flaherty & Crumrine/Claymore Preferred Securities Income Fund (FFC),
- Spectrum Asset Management's Nuveen Quality Preferred Income Fund 2 (JPS), and
- John Hancock's Preferred Income Fund II (HPF).
It's high noon in the showdown, let's get to the last man standing.
An overview of the three funds is as follows:
Investment allocation by asset class is as follows:
As shown by the above table (from company filings), Spectrum has the lowest allocation to preferred stock. Cash is lowest at Flaherty and equities are highest at Hancock. All in all, while allocations differ somewhat, there is nothing that is overly disconcerting within any of their allocations.
Flaherty and Crumrine:
Flaherty and Crumrine is an investment adviser specializing in the management of preferred securities. Founded in 1983, our historic knowledge and dedicated credit research capabilities have allowed us to provide clients with the individualized attention needed to withstand dynamic markets. With an eye towards the long-term, we are committed to helping our clients navigate intricate preferred securities markets. For individuals, we offer a family of five closed-end funds which invest primarily in preferred securities.
Spectrum Asset Management:
Spectrum Asset Management is a world-leading manager of preferred securities, with over US$13.4 billion in assets under management as of December 31, 2011. Spectrum was founded in 1987 and has been a wholly owned and independently run affiliate of Principal Global Investors, a member of the Principal Financial Group since 2001. Spectrum has a team of seventeen dedicated investment professionals and is based in Stamford, Connecticut.
John Hancock Financial is a unit of Manulife Financial Corporation, a leading Canadian-based financial services group serving millions of customers in 22 countries and territories worldwide. The Boston-based mutual fund business unit of John Hancock Financial, John Hancock Funds, manages more than $66.4 billion in open-end funds, closed-end funds, private accounts, retirement plans and related party assets for individual and institutional investors at December 31, 2011.
Gregory K. Phelps is a senior managing director and senior portfolio manager at John Hancock Asset Management. Mr. Phelps Joined the team in 2003, joined the subadviser in 2005 and joined the adviser in 1995. Mark T. Maloney is a managing director and portfolio manager at John Hancock Asset Management. Mr. Maloney joined the team in 2003, joined the subadviser in 2005 and joined adviser in 1982.
Flaherty & Crumrine (from the fund site): The Fund's investment objective is high current income for holders of its common stock consistent with preservation of capital. At least 80% of the Fund's total assets will be invested in a diversified portfolio of preferred securities. The Fund expects that its portfolio of preferred securities will consist principally of 'hybrid' or taxable preferreds. At least 80% of the Fund's preferred securities will be investment-grade quality at the time of purchase. Up to 20% of the Fund's total assets may be invested in securities rated below-investment grade (but not below Ba3 or BB-), provided the issuer has investment-grade senior debt outstanding. The Fund's investment adviser intends to pursue strategies that it expects generally to result in the Fund's income increasing in response to significant increases in long-term interest rates while being relatively resistant to the impact of declines in long-term interest rates. There can be no assurance the Fund will achieve its investment objectives.
Spectrum (from the N-CSR): The investment objective of each Fund is to earn high current income consistent with capital preservation. Each Fund's secondary objective is to enhance portfolio value. Under normal market conditions, the Funds seek to invest at least 80% of their net assets in preferred securities and up to 20% in debt securities, including convertible debt securities and convertible preferred securities. We also maintain approximately a 60% weighting to U.S. names and a 40% weighting to foreign names as part of the basic strategy that keeps all the Funds in a neutral position relative to the benchmark.
Hancock (from the annual report): The Fund's primary investment objective is to provide a high level of current income, consistent with preservation of capital. The Fund's secondary investment objective is to provide growth of capital to the extent consistent with its primary investment objective. The Fund seeks to achieve its objectives by investing in securities that, in the opinion of the Adviser, may be undervalued relative to similar securities in the marketplace. Under normal market conditions, the Fund invests at least 80% of its assets (net assets plus borrowings for investment purposes) in preferred stocks and other preferred securities, including convertible preferred securities.
Manager style in a preferred CEF context can be somewhat determined by portfolio concentration, sector allocation and portfolio turnover.
Portfolio concentration - Ideally, if an investor wants a stable return (payout) portfolio, the manager should not have overly concentrated positions (or sectors to be addressed next). A review of the top ten holdings should give us a feel for the concentration of the portfolio. What we are going to look for is positions greater than 5-10% and significant sector concentration within the top ten holdings. Let's take a look:
Of the three managers, Flaherty runs the most concentrated portfolio, with the top ten holdings accounting for 36% of the portfolio. At 36%, the concentration in the top ten holdings is not an undue risk, but two positions are greater than 5%, which is typically my comfort level (although literature suggests that a portfolio is diversified with less than twenty names which would put position sizes at 5% or greater). Santander is also in the spotlight as being a large Spanish bank (although I, personally, think their business model and risk management are strong). One interesting note is the virtual lack of overlap between the managers, which implies they are not "herd" investors - a positive attribute for all three. Based on the portfolio holdings concentration, I do not see that any of the managers have undue risk exposure, so no managers get "dinged" for portfolio concentration. (data from company filings)
Sector allocation - Part of a manager's style can be determined by their sector/industry distribution. If a fund/portfolio is too focused in any one sector, the manager is making a "bet" on the sector and returns can be volatile. For our purpose, we desire a portfolio that is diversified among sectors and has stable constituents as well as higher beta constituents. Let's have a look:
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A couple things that strike me right off the bat is the difference between the allocations of the managers. Flaherty has the largest allocation to banks and finance at 42% while Hancock and Spectrum are around 35%. Hancock has the most sector diversified portfolio as insurance accounts for less than 10% (versus 25% and 32% for Flaherty and Spectrum respectively) and the other category is 28% (versus 7% and 14% for Flaherty and Spectrum respectively). What strikes me as interesting is Spectrum's low allocation to utilities, typically used to dampen volatility and smooth returns. (data from company filings)
Portfolio turnover - A manager's style can often be viewed as a "closet benchmarker" or an "active manager". A benchmarker will often "set it and forget it" and have very low portfolio turnover, whereas an active manager will have a greater turnover as they attempt to optimize their portfolio. Lets see how our funds look in this respect:
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As the above chart (taken from company filings) shows, the three managers have different styles of portfolio management when it comes to trading portfolio positions. I personally like to see a decent amount of turnover as this implies the manager is actively controlling positions/exposures and taking advantage of opportunities as they arise. In this context, Flaherty has the highest turnover without it being excessive (in my opinion). As I wrote in the Showdown Part III, I would like to see more turnover out of Hancock as the portfolio turnover seems more like redemptions and some trading rather than actively optimizing the portfolio. Spectrum falls smack dab in the middle, although turnover fell off a cliff in 2011. Hopefully they will return to prior turnover levels - especially as the preferred market has been more active this year than last year.
Ratings - Often a manager's style can be reflected in the portfolios' ratings distribution. For a "current yield" based portfolio, a large concentration in high yield can reflect higher risk based yield and hint to future volatility and difficulty maintaining current distribution rates.
The above table (taken from company filings) shows that Flaherty's portfolio has more credit risk than their peers, which really is not much of a surprise given their allocation to banks and finance (whose preferreds were downgraded during the downturn and stand to be further downgraded as the rating agencies have announced). Of the three managers, Spectrum has the most conservative portfolio from a ratings perspective. From a stability perspective, Spectrum has the advantage here.
Returns are the easiest aspect of our analysis as they are the result of all the factors analyzed.
As the above table shows, Flaherty has had the highest one and three year returns and had a second place showing in the five year term. This is partially due to their 2009 return of over 80% and their leverage (which is highest of the three). Spectrum's returns have lagged over the one and five year terms while taking second in the three year term. Hancock has turned in very respectable returns, with much less of a loss in 2008 due to their conservative nature and lower exposure to the volatile financial sector.
Reaching a conclusion as to which manager/fund is the superior fund has been a very difficult task. The choice, to a degree, comes down to the risk tolerance of the individual investor. For those with a greater risk tolerance, Flaherty's FFC is an attractive fund - although its premium gives me pause as it normally trades at a discount and might revert back to a discount. Hancock's fund is the most balanced and stable of the three and is best suited for investors who are looking for a decent yield and a conservative risk profile. Spectrum's portfolio characteristics and management has not translated into returns over time. While I know the firm to be very talented and have deep knowledge of the preferred markets, it has not translated into the performance I would require from an investment.
Bottom line: Of the three, I have to give Hancock the top slot due to their conservative nature and their stable returns. While I would normally go with Flaherty, I would keep an eye on the premium and if it swings to a discount, I would reassess. As it stands, Hancock has the steadiest hand and their bullets find their marks - they walk away as the winner of the shootout.