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The Holy Grail of Preferred ETFs?

By Ari Charney on January 13, 2017

Although we’re well into the digital age, I still occasionally receive snail mail from subscribers.

Indeed, the other day I spied a bulging manila envelope in my mailbox, with my name and address handwritten on the exterior. “Uh-oh,” I thought to myself, “This can’t be good.”

While my interactions with subscribers are generally rewarding, sometimes I have to take a bit of heat. After all, it goes with the gig.

As I walked back to my office with the envelope tucked under my arm, my mind ran a little wild.

I imagined the envelope had been stuffed with several months’ worth of back issues of Utility Forecaster, crumpled but then flattened back out, with feverish scrawling in the margins and angry slashes of highlighter across the text.

You can tell I’m a worrier because I had these thoughts even though our portfolios performed quite well last year, returning an average of 23.6%, which was well ahead of both our benchmarks and the broad market. Still, there’s no pleasing everyone.

When I got back to my office, I ripped open the envelope, and I was … greatly relieved by what I saw. Turns out it was a subscriber with whom I had previously chatted, and he had some very kind words to say about a recent recommendation.

The security that I had written about is a closed-end fund that specializes in preferred stocks, primarily in the utility sector, and offers a mouth-watering yield of 7.5%.

But there are also some significant caveats.

Like many of its closed-end peers, the fund employs substantial leverage to boost yield and returns.

Though the fund focuses on preferreds and utilities, it’s not a pure-play on either.

About one-third of assets are currently allocated to equities, giving the fund a somewhat higher risk profile than it would have if it focused solely on preferreds.

And while the portfolio’s overall sector allocations lean toward utilities, at 44% of assets, a sizable chunk is invested in financials (35% of assets), which also boosts the fund’s risk profile.

From Active to Passive

Although passively managed funds, such as ETFs, are attracting a growing share of investor dollars, I’m still a big believer in the ability of a talented fund manager to deliver market-beating returns over the long term. While it’s hard to do, it can be done.

But I’m certainly willing to go the ETF route if there’s a dearth of actively managed funds for certain niches.

In this case, my correspondent had done some research of his own and shared the product of his efforts. While he’s quite happy with the closed-end fund that we recommended, he’s always on the prowl for new income investments.

You see, he took my critique of the closed-end fund to heart and found another security that on its face would seem to offer more of what we’re looking for: VanEck Vectors Preferred Securities ex-Financials ETF (NYSE: PFXF).

The ETF eliminates three of our concerns regarding the risks associated with the aforementioned closed-end fund: It doesn’t use leverage, it invests in preferreds and other debt and hybrid securities that are considered “functionally equivalent” to preferreds, and it removes exposure to the financial sector.

And with an annual expense ratio of just 0.40% (thanks in part to a fee waiver), PFXF is the cheapest preferred ETF on the market.

You get all of that and a yield of 5.8%.

So What’s the Catch?

Naturally, you’re probably wondering whether it’s too good to be true.

While financials and utilities issue the vast majority of preferreds, PFXF’s “ex-financials” designation doesn’t mean we’re left with a pure-play on utility preferreds.

Indeed, hybrid securities issued by real estate investment trusts (REITs) account for a substantial 27.9% of assets. So one sector risk gives way to another.

Securities issued by electric utilities and telecoms—the kind of firms that Utility Forecaster tracks—account for 28.7% and 14.9% of assets, respectively, for a total of 43.6% of assets.

In fact, among the ETF’s top-10 holdings, which account for 23.3% of assets, four of the securities were issued by companies whose stocks we hold in our Growth and Income Portfolios.

The remaining sector allocations cover a number of industries ranging from aerospace (1.3%) to insurance (4.8%). Hmm, the latter suggests that perhaps this fund doesn’t quite deserve its “ex-financials” status after all.

Other Considerations

It also should be noted that because PFXF holds securities that are considered “functionally equivalent” to preferreds, but aren’t actually preferreds, most of the income generated by this ETF is not considered “qualified” for tax purposes.

Last year, for instance, just 19.8% of the fund’s monthly distributions were sourced from qualified dividends. That means the ETF should be held in a tax-advantaged account, such as an IRA.

PFXF’s diversity of securities, which include convertibles and perpetual subordinated debt, doesn’t just affect taxation. It also means that this fund’s risk profile is more complicated than it would be if it invested solely in preferreds.

About 50% of the fund’s 118 holdings are investment grade, which is actually better than it sounds, at least as far as preferreds go. Since preferreds rank lower in a firm’s capital structure than debt, their ratings are typically a notch or two below that of the issuer’s bonds, which means many preferreds get knocked down to speculative grade, or “junk.”

At the same time, about 37% of the ETF’s holdings are unrated, which makes it difficult to gauge overall credit risk.

Over the period since PFXF’s inception in July 2012, its net asset value has lagged our aforementioned closed-end fund by about 10 percentage points.

But given their differing characteristics, that’s not an entirely fair comparison. And it certainly doesn’t mean that PFXF has been a poor performer. Over the trailing three-year period, the ETF has returned 6.5% annually, which is in line with Morningstar’s benchmark for preferreds.

Despite the fact that PFXF is not quite what it seemed at first glance, it could play a supporting role in income investors’ portfolios, as long as they’re comfortable with the risks.

Of course, with rates heading higher, we’re at an interesting juncture for preferreds and other rate-sensitive securities. So it may be worth monitoring PFXF for a little while to get a sense of how its value fluctuates with rate expectations.

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