Preferred Stock ETFs: Not Created Equal

Includes: PFF, PGX
by: Yieldpig

As much as the crusty and stubborn Jack Bogle hates to admit it, ETFs have taken cost-effective investment management to a whole new level, trumping his bulky, lumbering open-ended index fund (he vetoed the idea of creating an ETF during his time at the helm of Vanguard). As with the swift proliferation of any new, innovative product, the choices and nearly identical similarities often reach a confusing and dizzying heights. One prime example is the case of two well-known preferred stock ETFs: the iShares S&P U.S. Preferred Stock Index Fund (NYSEARCA:PFF) and the PowerShares Preferred Portfolio (NYSEARCA:PGX).

Although they each track a different index, PFF and PGX share many traits when compared side by side. Both baskets trade close to their 52-week highs primarily due to investor hunger for yield. PFF yields 6.22% vs. PGX's 6.36%. 91% of PGX's holdings are in the financial sector, while PFF's bucket is 83% financials. They even share seven of the same top 10 holdings.

While the heavy weighting toward financials in both of these ETFs would normally be a major concern, the Durbin Amendment of the Dodd-Frank financial reform bill actually mitigates some of the over concentration risk. The Durbin amendment prohibits banks from including trust preferred stocks as part of their Tier One Capital (the most important measure of a banks financial health), and gives them until 2013 to restructure as such. Thanks to this rule and ridiculously low interest rates, most larger banks have been retiring or refinancing their trust preferred stock. Basically, this has supported the preferred market as a whole, keeping prices at par (usually $25 a share) and aiding in the outperformance of preferred stock ETFs.

In fact, the similarities PFF and PGX share outweigh the differences. But the differences are significant and deserve investor attention.

An obvious, albeit trivial, difference is the share price. PFF flirts with an all-time high of near 40 while PGX, also bumping on a high, trades at a seemingly more affordable 14.80. They also track different indexes. PFF is modeled to mimic the S&P U.S. Preferred Stock Index, while PGX follows the Bank of America/Merrill Lynch Core Fixed Rate Preferred Securities Index. However, the major difference is the credit quality of each portfolio.

While the largest credit rating agencies, Moody's and Standard & Poor's, still carry the scars and bruises resulting from less-than-stellar judgment during the subprime mortgage brouhaha and the subsequent financial crisis of 2008, their ratings still carry weight when it comes to security selection. Many preferred securities, especially those from bigger name issuers, carry credit agency ratings that are commensurate with their respective corporate bond ratings. According to the fact sheets issued by the management companies of each ETF, 64% of the PGX basket carries an investment grade rating by S&P of BBB or better and 48% of the names held carry a Moody's investment grade rating of Baa or better.

I was shocked, however, when I analyzed the credit quality of PFF's portfolio. Only 44% of the portfolio has the BBB or better S&P rating, while only 0.57% carries the Baa or better from Moody's.

Another major difference are the respective betas -- a measure of the investment's volatility compared to its benchmark -- of each ETF. According to Morningstar, PFF's average three-year beta was 0.36. That's not bad if you consider that the benchmark beta will always be 1.00. However, PGX sports an impressive three-year beta of only 0.23. This means the price fluctuation of PGX is 36% less volatile than PFF.

Now, keep in mind that although preferred stocks are senior to the common stock of the issuer, they are still junior to a company's bonds and bank debt. Therefore, while they make a great addition to a portfolio, as with any investment, prudence must be practiced.

Both PFF and PGX provide exposure to a broad spectrum of preferred stocks and provide above-average, inflation beating (for now) income. But both names look a bit stretched out on the price side. It probably makes the most sense to wait a bit for a pullback before adding either of these names. Based on better credit quality and lower volatility, looking at PGX first would probably be the best course of action.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

About this article:

Author payment: $35 + $0.01/page view. Authors of PRO articles receive a minimum guaranteed payment of $150-500. Become a contributor »
Problem with this article? Please tell us. Disagree with this article? .