FPE: A Unique Approach To Generating Income

Summary

• FPE offers investors a high yield, low volatility, and a steady income.
• FPE is significantly more diversified than competing preferred stock ETFs.
• FPE's high expense ratio and comparatively risky credit rating may put off some investors.

Investment Thesis

Last summer, I wrote two articles for Seeking Alpha in which I examined six of the most popular preferred stock ETFs. In the first of those articles, I took a look at the Invesco Preferred Portfolio ETF (PGX), the iShares Preferred and Income Securities ETF (PFF), and the VanEck Vectors Preferred Securities ex Financials ETF (PFXF). In response to a lively discussion in the comments of that article, I penned a second article in which I looked at another three preferred stock ETFs that, in my estimation, were somewhat less appealing.

A few months later, in November, I was invited to revisit PFXF in a follow-up piece for Seeking Alpha. Then, in February, I was invited to revisit PGX. This past July, I published an article in which I re-examined PFF and a follow-up in which I took a closer look at the SPDR Wells Fargo Preferred Stock ETF (PSK). Last month, I published a third article on PGX in which I examined some of the developments that might be of interest to investors considering initiating or expanding a position in the fund.

From time to time, readers would email me or send a direct message to my Twitter account to ask about preferred stock funds I had not yet covered for Seeking Alpha. Motivated in part by some of those messages, I decided to take a look at the First Trust Preferred Securities and Income ETF (NYSEARCA:FPE) for the eighth article in this series.

Unlike the funds featured in the previous articles, however, FPE is not a pure preferred stock ETF. Rather, the fund's basket of holdings includes both preferred stock and convertible bonds which, while sharing some similarities, are distinctly different investment vehicles. This article will consider the benefits and drawbacks of FPE, as I see them, to determine if the fund is a good alternative to the pure preferred stock ETFs I have previously examined and, further, to decide whether now is a good time to open a position in the ETF.

Why Invest In Preferred Stock?

For the benefit of readers who may not be as familiar with preferred stock, I think it is important to review some of the basic reasons investors might want to include it in their portfolios. Preferred stock is a rather unique type of equity that might best be described as a hybrid investment vehicle combining characteristics associated both with bonds and common stock. Like bonds, preferred stocks tend to appeal to income-oriented investors seeking a steady, predictable stream of cash. While preferred stock can appreciate or depreciate, shares have a par value that tends to prevent them from trading outside of a comparatively narrow price range.

Thus, preferred stock rarely offers investors much in the way of capital appreciation. Instead, it offers investors a substantial yield, often well in excess of 5%. Furthermore, preferred stockholders enjoy preferential treatment in the event of a company's financial distress. If, for instance, a company must liquidate its assets to pay its creditors, bondholders will be paid first, followed by preferred stockholders. Common stockholders will get whatever is left, if anything. Similarly, when a company suspends or cuts its dividend to common shareholders, preferred stockholders will continue receiving their checks. Lastly, preferred stockholders often benefit from qualified dividends that are classified as capital gains rather than ordinary income.

Why Preferred Stock May Not Be Right For You

Those benefits understandably appeal to many income-oriented investors, but there are some significant downsides to investing in preferred stock that must also be taken into consideration when looking to initiate or add to a position. As I mentioned above, preferred stock almost never offers investors significant capital appreciation. Thus, if you're seeking growth, you'd best look elsewhere. Another drawback to preferred stock that investors may want to consider is the very real possibility that a company will issue a share call. Like bonds, preferred stock generally has a maturity date set decades in the future.

However, after five years, a company can call the outstanding shares of its preferred stock, which they will often do if it is financially advantageous for them to do so. They'll pay you the par price, and you'll have lost an income stream. A third consideration investors will want to keep in mind before buying preferred stock is interest rate sensitivity: When interest rates go up, the appeal of preferred stock tends to weaken. In a rising interest environment, common stock becomes more appealing because they can offer higher yields while the fixed yield of preferred stock may even pull their share prices down - and prices can drop hard. With the Fed slashing interest rates in 2019 and virtually eliminating them earlier this year, this last consideration might not seem all that pressing, but it is well worth bearing in mind when looking at preferred stock.

How Convertible Bonds Compare To Preferred Stock

Although I expect many of my readers will not need any explanation of convertible bonds, I will briefly review a few key similarities and differences here for the benefit of readers who may not be as familiar with this particular type of bond. Like preferred stock, convertible bonds exhibit traits investors associate with both the stock market and the bond market. Perhaps most notably, both instruments can convert to common stock, enabling investors to profit from a jump in the company's valuation. Both vehicles also have callable versions, meaning that if a preferred stock's dividend or a bond's interest payment exceeds prevailing interest rates, a company can exercise a call and pay investors a pre-determined price or par value.

While the similarities between the two types of investment are many, the differences are also important. Significantly, most of these differences can be chalked up to the fact that preferred stock is equity while convertible bonds are instruments of debt. For instance, while changes in interest rates impact the market value of both preferred stock and convertible bonds, the price changes tend to be less noticeable on the former than the latter because the bond market often responds more strongly to rising interest rates. For some particularly volatility-averse investors, then, convertible bonds may be less appealing than preferred stock. On the other hand, bonds have priority over preferred stock for payments due, meaning that income generated by convertible bonds offers even more security than that produced by preferred stock. In a related vein, preferred stock dividends are subject to board approval while paying interest on bonds is not, so investors may find holding a company's convertible bonds help them sleep better when that company experiences financial distress. Another benefit convertible bonds offer when compared with preferred stock is that they tend to hold higher credit ratings than preferred stock.

The Pros And Cons Of FPE

Pro #1: Yield

As I have discussed in my previous articles on the subject, since most investors turn to preferred stock as a way to generate a predictable stream of income, the first thing I look at when evaluating a preferred stock ETF is the fund's yield. FPE, like the other funds I have examined in this series, consistently offers a yield north of 5%, though it currently sits at its lowest point in five years. As of the close of trading on Friday, December 11, FPE's yield is a hair below that 5% mark, clocking in at 4.95%:

Data by YCharts

As we can see, FPE's yield has steadily decreased over the past year or so. Of course, much of this decrease is the result of the ETF's share price climbing as fixed-income investors respond to anemic interest rates currently on offer after the Fed slashed them in March and April. Still, at nearly 5%, FPE offers a yield very much in line with those offered by the pure preferred stock ETFs I discuss in this series:

Data by YCharts

For investors looking for a comparatively secure yield in the 5% range, FPE looks to be a solid choice.

Pro #2: Diversification

As I have frequently mentioned in the previous articles in this series, one of my biggest concerns with many preferred stock ETFs is their tendency to concentrate heavily in the financial sector. While financial institutions account for over 60% of the holdings in both PFF and PGX, FPE is somewhat lower, with banks, insurance, and diversified financial services totaling 55.84%:

(Source: First Trust)

While a five or ten percent difference in a fund's allocation to financials might not seem significant, FPE's lower concentration in financial institutions may appeal to investors wary of disruptions in the sector.

Similarly, I have often expressed some concern that the preferred stock ETFs I have discussed most frequently in this series are not geographically diverse. For instance, more than 94% of PFF's holdings reside in the United States:

(Source: iShares)

With nearly 96% of its holdings in U.S. companies, PGX is even less geographically diversified than PFF:

(Source: Invesco)

By comparison, less than 50% of FPE's holdings are concentrated in the United States, with the remaining holdings spread out among several different (though primarily European and North American) countries:

(Source: First Trust)

While many investors remain bullish on the U.S. economy, the geographic diversity of FPE may provide investors with some degree of protection in the event of a major economic downturn in the U.S.

Pro #3: Active Management

For investors wary of funds that passively track indices such as PFF and PGX, FPE offers active management. While such a hands-on approach does come at a premium (see Con #3 below), it does provide investors with a sense that the fund will respond to market conditions more proactively than its passively-managed peers. Stonebridge Advisors LLC, FPE's management team, prides itself on being "a niche asset management firm that provides highly specialized expertise in preferred and hybrid securities." Compared with passively-managed ETFs, FPE is able to rotate in and out of sectors, respond to the vicissitudes of micro- and macroeconomic conditions, and consider risks in real-time, as illustrated in the fund's investor's guide:

(Source: First Trust)

For investors concerned with an ETF's ability to respond to market conditions, an effective and active management team can provide a modicum of comfort.

Con #1: Not-So-Low Credit Risk:

As mentioned earlier, because bonds tend to have higher credit ratings than equity, one might expect FPE to offer a lower credit risk than either of the two pure preferred stock ETFs I discuss in this article. Somewhat disappointingly, its credit ratings are comparable to both PFF and PGX. If we regard ratings below BBB- to be speculative, as S&P urges investors to do, PFF offers the highest percentage of investment grade holdings, with nearly 68% rated BBB or better:

(Source: Morningstar)

By contrast, only 55% of PGX's holdings enjoy a BBB or higher rating from S&P:

(Source: Invesco)

Despite the hope that the fund's allotment of bond holdings might push its credit rating higher than those of the two aforementioned pure preferred stock funds, roughly 61% of its holdings rated BBB- or better, FPE falls closer to PGX than PFF:

(Source: First Trust)

Thus, while FPE enjoys a bit more favorable credit rating than PGX, it does not stand out as a particularly enticing investment, especially given PFF's marked advantage.

Con #2: Fewer Assets Under Management

Last May, Moody's Investor Research issued a warning for investors owning "ETFs tracking inherently illiquid markets," arguing that "[t]hese ETF-specific risks, when coupled with an exogenous systemwide shock, could in turn amplify systemic risk." Since preferred stocks are such a thinly-traded segment of the market, ETFs focusing of them run the liquidity risks highlighted in the Moody's report. Of the three ETFs I examine in this article, PFF, at $18.95 billion in assets under management, is the clear leader. PGX and FPE trail with $6.84 billion and $5.82 billion in assets under management, respectively:

Data by YCharts

As one might expect given the above information, FPE trades at an appreciably lower volume than either PFF or PGX:

Data by YCharts

Con #3: The Expense Ratio is a Bit High

According to the Wall Street Journal, the average expense ratio for an ETF is 0.44%. Of the three funds I discuss in this article, FPE has the highest expense ratio, by far. As an actively-managed fund that does not track an index and, thus, requires more effort to run, this is not a surprise. At 0.85%, however, FPE is a full 0.33% higher than PGX's 0.52%, and 0.39% higher than PFF's 0.46%. This means that, for every $1,000 you invest in the fund, PFF will charge you $4.60, PGX will charge you $5.20, and FPE will charge $8.50. While $3.30 or $3.90 out of a thousand dollars might not seem like much, it adds up over time and some investors may find that FPE's higher expense ratio may detract from the fund's appeal.

Final Thoughts

FPE is an interesting option, though not one I am inclined to buy at the moment. While I appreciate a good management team actively running an ETF, I am put off by the fund's high expense ratio. If the ETF significantly outperformed such popular funds as PFF and PGX, I might be inclined to take another look at FPE, but it has not distinguished itself as a particularly high achiever in the preferred stock space. Furthermore, while I do get the impression that Stonebridge Advisors is a solid management firm, I find their willingness to take on credit risk does not meet my current investment objectives. That said, I do like the fund's use of convertible bonds to complement preferred stock in generating income. The ETF is also strikingly diverse both in sector allocation (compared with some of its financially-oriented peers, at least) and in its geographic allocation. For income-oriented preferred stock investors looking for that sort of diversification and who appreciate active management, FPE may well be a good choice. For me, though, I'll place the ETF in my "maybe another time" list.

As always, I appreciate any comments, questions, corrections, or suggestions my readers may have and encourage you to use the comment section below to initiate discussion, share your thoughts, or ask questions.

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Disclosure: I am/we are long PGX. 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.