As the ETF industry has expanded in recent years, so too has the number of asset classes accessible through exchange-traded products. With more than $2 billion in cash inflows in 2009, preferred stock ETFs have become a big hit with some investors, offering “hybrid” exposure that has delivered strong returns provided valuable diversification benefits to traditional portfolios split between stocks and bonds.
These days, it’s good to be a hybrid. In an increasingly eco-friendly environment, you can’t drive a block in most cities without coming across a hybrid car. Hybrid clubs are the latest golf fad, with every amateur hacker out there scooping up one of these ‘wonder clubs’ to take a few strokes off their game. And in the ETF industry, preferred stock ETFs, which are a type of hybrid between traditional equities and bonds, are soaring.
Preferred stocks are by no means a new financial innovation, and have been a preferred financing source for many financial companies for decades. Among the traditional features of preferred stock:
- Usually carry no voting rights
- Entitled to dividends (usually at a fixed rates) that are subordinate to debt payments but senior to dividends on common stocks
- May be convertible to common stock at a predetermined conversion ratio
- Paid out after debt holders but before common shareholders in the event of liquidation
As such, preferred equities are like similar to debt in that they are generally entitled to a fixed dividend payment, reducing the volatility of the cash flows they generate. But they may also maintain upside potentials typically associated with equities (if convertible), along, of course, with the commensurate risk (potential to be left empty-handed in the event of a bankruptcy).
Drivers Of Preferred Stock ETFs
With characteristics of both stocks and bonds, preferred stock ETFs can be impacted by a number of factors, including:
- Interest Rates: Fixed income prices and interest rates are inversely related, meaning that fixed income prices will rise as interest rates fall. As rates fall, existing debt issues with higher interest rates become more competitive, and demand for these products increases. However, if interest rates decline significantly, callable bonds may be redeemed by the issuer, forcing investors in these bonds to reinvest their proceeds at a much lower coupon rate (or seek exposure to another asset class). Sensitivity to interest rate changes is positively correlated with time until maturity.
- Underlying Stock Fundamentals: Since many securities underlying ETFs in this ETFdb Category are convertible to common stock in certain circumstances, the performance of the equity markets will impact prices of these ETFs. As equity prices rise, the “option” to convert to common equity increases in value. Likewise, when stock prices decline, the option is further out of the money, and the value of the preferred security declines.
- Liquidity: In certain environments, the trading markets for preferred securities may be far less active than markets for corresponding common shares. This can create a disconnect between the value of the preferred share and the value of the common share. It can also be harder to sell preferred stock since the market is so illiquid compared to either common stock or even corporate bonds.
Preferred Stock ETF Options
|Preferred Stock ETFs|
|As of December 18, 2009|
Despite its popularity as a means of raising capital, preferred stock investments have been slow to catch on in the ETF world. But these funds delivered relatively strong performances throughout 2009, as a broad market rally has reduced fears of a wave of bankruptcies and sent investors rushing back into preferred stocks. The four preferred stock ETFs highlighted below have seen aggregate cash inflows of more than $2.2 billion through the first 11 months of 2009, an impressive haul [Download 101 ETF Lessons Every Financial Advisor Should Learn].
Among the most popular preferred stock options on the market today:
- PowerShares Financial Preferred Portfolio (PGF): This ETF, which tracks the Wachovia Hybrid & Preferred Securities Financial Index, focuses exclusively on preferred issues from financial institutions and maintains approximately 30 holdings. Holdings of this ETF include preferred stock issued by Bank of America, Wells Fargo, and JP Morgan Chase, as well as international banks like Barclays, ING Groep, HSBC, and Credit Suisse (see PGF’s holdings here).
- iShares S&P U.S. Preferred Stock Index ETF (PFF): This preferred stock ETF, which is dominated by holdings in financial companies, is the largest on the market, with a market capitalization of more than $3 billion and an average daily volume of nearly 1 million shares (see PFF’s technicals here). In addition to preferred stock issued by financials firms, PFF holds securities from companies Archer Daniels Midland and certain real estate investment trusts (see PFF’s fact sheet here).
- PowerShares Preferred Portfolio (PGX): PGX offers more a lightly more diversified exposure to the preferred stock market than PowerShares’ other offering, tracking the broader Merrill Lynch Fixed Rate Preferred Securities Index and maintaining more than 65 holdings. More than 85% of PGX’s holdings are in the financial sector. Although it has underperformed PGF, PGX is still up more than 90% from its March low (see PGX’s performance charts here).
- SPDR Wells Fargo Preferred Stock ETF (PSK): The newest preferred stock ETF, PSK is tilted towards the financial sector but also holds securities from companies in a variety of industries, including AT&T, Comcast, and General Electric. This ETF was launched in September 2009 (see PSK’s fundamentals here).
Disclosure: No positions at time of writing.