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Preferred stock ETFs are popular investments during low interest rate environments due to their attractive yields. According to Markit, assets under management soared more than 12 times between 2008 and 2016 to $27.2 billion. The majority of those gains occurred in 2009 and 2010, and again in 2015 and 2016, during periods of exceptionally low interest rates. The problem is that these trends can quickly reverse in a rising interest rate environment.
Figure 1 – Preferred Stock ETF Inflows – Source: Markit
In this article, we will take a closer look at these trends along with some important considerations for investors interested in the asset class.
What Is Preferred Stock?
Preferred stock is simply a type of equity that has a higher claim on assets and earnings than common stock. Often times, preferred stocks have a dividend that must be paid out before dividends to common shareholders. The downside is that preferred stocks usually do not include voting rights, which means that investors have limited say in the direction of the company when it comes to voting for directors or other matters.
Here are some important differences between the two:
| Common Stock | Preferred Stock | |
|---|---|---|
| Dividends | May or may not be paid out depending on how the Board of Directors votes. | Paid out on a regular schedule that is much more predictable. |
| Claim on Assets | Last to be paid if a company moves into bankruptcy. | Paid after bond holders and ahead of common stock investors. |
| Volatility | High level of volatility depending on a company’s earnings and other factors. | Less volatility due to the regular dividend payments and greater claim on assets. |
| Liquidity | High level of liquidity with a large number of investors buying and selling. | Less liquidity due to fewer buyers and sellers. |
| Voting Rights | Standard voting rights in corporate matters. | No (or restricted) voting rights. |
Preferred stocks may also be callable or convertible depending on the issuer. Callable stocks mean that issuers can repurchase the shares at par value after a set date. Convertible stocks mean that investors can exchange the preferred stock for a set number of common stocks under certain conditions. These are important features that can affect the price of the preferred stock and potentially change its value to a given investor.
Preferred Stock ETFs
Preferred stock ETFs hold a portfolio of preferred stocks in a single security. For example, the iShares S&P U.S. Preferred Stock ETF (PFF ) holds nearly 300 different preferred stocks across the U.S., the U.K. and the Netherlands. The ETF’s modest 0.25 beta coefficient shows just how little volatility it has relative to common stocks, while its 3.76% dividend yield highlights the income returns that investors can expect (data as of September 6, 2016).
The most popular preferred stock ETFs, include:
| Symbol | Name | Dividend Yield | Total Assets* | Expense Ratio |
|---|---|---|---|---|
| (PFF ) | iShares U.S. Preferred Stock ETF | 3.76% | $17,789,736 | 0.47% |
| (PGX ) | PowerShares Preferred Portfolio ETF | 5.60% | $4,731,654 | 0.50% |
| (PGF ) | PowerShares Financial Preferred Portfolio ETF | 5.51% | $1,843,989 | 0.63% |
| (FPE ) | First Trust Preferred Securities and Income ETF | 5.96% | $1,166,714 | 0.87% |
| (VRP ) | PowerShares Variable Rate Preferred Portfolio ETF | 4.45% | $820,160 | 0.50% |
Investors interested in these ETFs should be aware of the funds’ strategy and expense ratios. In general, ETFs with higher expense ratios tend to generate below-market returns for investors. Some ETFs are also focused on specific sectors, such as the PowerShares Financial Preferred Portfolio ETF’s (PGF ) focus on the financial sector. These concentrations may reduce diversification and increase risk in the event that a specific sector experiences a downturn.
Benefits & Drawbacks
There are many different benefits and drawbacks that investors should carefully consider before purchasing preferred stock ETFs.
Benefits of preferred stock ETFs include:
- Diversification. Preferred stock ETFs are diversified in a way that reduces the risk of holding an individual preferred stock. For smaller investors, this is valuable, because purchasing a diversified portfolio can require a lot of capital upfront.
- Liquidity. Preferred stock ETFs are generally pretty liquid, which means that investors can easily buy and sell them. In contrast, many individual preferred stocks are a lot less liquid and may entail greater risk when there’s limited ability to sell.
Risks of preferred stock ETFs include:
- Limited Upside. Preferred stock ETFs often trade near their issuance price, which limits the capital gains potential compared to common stock. With preferred stock ETFs, investors should primarily be looking at the yield when investing.
- Valuation Risk. Preferred stocks and preferred stock ETFs trading above their par value may be at risk of a decline, if interest in their yields dries up. Often times, the risk of price decline is higher during periods of rising interest rates.
The Bottom Line
Preferred stock ETFs tend to be popular investments during low interest rate environments, but there are some important risks that investors should keep in mind. In particular, the risk of rising interest rates could lead many preferred stocks trading above par value to revert to the mean and lose value. Investors should keep these risks in mind and ensure that preferred stocks represent just a portion of an overall diversified portfolio.
