ETF portfolios offer tempting yields after sell-off, but risks abound
By John Spence, MarketWatch
Last update: 12:29 p.m. EST Nov. 9, 2008
BOSTON (MarketWatch) — Preferred stocks took a big hit in September and October as the credit crunch and bank failures sent investors for the exits, but the shares have been garnering interest as their yields approach double digits.
Preferred issues have also attracted attention because famed investor and Berkshire Hathaway chief executive Warren Buffett has been buying them. Moreover, governments around the world have taken equity stakes in troubled banks through preferred shares.
Although investors shouldn’t expect Buffett-like deals, they can invest in a basket of publicly traded preferred shares via exchange-traded funds.
Many investors like to think of preferred shares as a blend of stocks and bonds. Preferred stocks, which generally don’t carry voting rights, tend to pay higher dividends than the common shares. Preferred shareholders receive their dividends before common shareholders and also have certain advantages if a company liquidates.
There are many types of preferred shares, including cumulative, callable and convertible. The prices of preferred shares typically have had more volatility than bonds but jump around less than common stock.
Another reason investors are drawn to preferred shares is that the dividends, which are fixed, can be taxed at a lower rate than the income thrown off by bonds.
Liquidity crisis
Preferred shares tumbled hard in October; iShares S&P U.S. Preferred Stock Index Fund (PFF) , an ETF managed by Barclays Global Investors, is off about 30% year to date. It has a 30-day yield of 9.3% and charges management fees of 0.48%.
Invesco PowerShares Capital Management also oversees a pair of preferred-stock ETFs: PowerShares Preferred Portfolio (PGX) and PowerShares Financial Preferred Portfolio (PGF).
The first big rumblings in the preferred market came after the government took over mortgage-finance giants Fannie Mae (FNM) and Freddie Mac (FRE), and the dividends on the preferred stock as well as the common equity were suspended.
The market was further shaken when Lehman Brothers failed and Washington Mutual was seized by the FDIC — in both cases the preferred stockholders were essentially wiped out.
As the credit crunch gained steam, there was a liquidity crunch in preferred shares with too many sellers and not enough buyers. Prices plunged and yields broke through 10% amid a flight to safety.
“A lot of high-net-worth individuals bailed on preferred shares in October,” said Scott Burns, Morningstar Inc.’s director of ETF analysis.
However, some financial professionals think the sell-off was overdone, and that investors who have an appropriately long time horizon and a stomach for risk can be rewarded for buying now.
Also, the U.S. government is taking unprecedented steps to shore up the financial system and prevent large-scale bank failures. One way the Treasury Department is pumping capital into the system is by taking equity stakes in companies through preferred shares.
Buying the basket
Mariella Jobson, portfolio manager for the iShares ETF, is extremely bullish on her sector.
Given the sizable yield and the potential for capital appreciation as the markets stabilize, a diversified basket of preferred stocks is “a very attractive” investment, she said, noting that some preferred shares are trading below par value.
“Even quality companies with solid fundamentals and balance sheets were punished,” Jobson said. “The market spared no one.”
Yet despite the carnage, money has flowed into iShares U.S. Preferred Stock, suggesting that some investors think the reward is worth the risk. Listed in early 2007, the ETF has seen net inflows of $750 million so far this year, and $360 million moved in during October alone, according to BGI.
“The financial crisis weighed down financials, but preferred shares are getting a lot of attention from the yields and also the investments by the government and Buffett,” said Greg Savage, an iShares portfolio manager.
The ETF holds 67 positions, and topping the list are preferred shares from banking giants Wells Fargo & Co. (WFC), Citigroup Inc. (C) and J.P. Morgan Chase & Co. (JPM).
In fact, about 90% of the iShares portfolio’s assets are in the financial sector simply because banks and insurance companies are among the largest issuers of preferred shares. Accordingly, investors should be aware that most of their investment will be tied up in the troubled financial sector. The ETF also invests in the real estate, materials, healthcare and auto sectors.
All of the ETF’s securities are listed in the U.S., although it does hold preferred shares of foreign firms, including ABN Amro Holding NV, Royal Bank of Scotland Group Plc and parent Barclays Plc (BCS) .
Some advisers also tout preferred shares for taxable accounts. About half of the issuers in the iShares ETF pay “qualified” dividends that are taxed at a maximum 15% rate. Income on bonds, however, is taxed at an individual’s ordinary income tax rate.
PowerShares
Invesco PowerShares offers two preferred-stock ETFs.
PowerShares Preferred Portfolio has an expense ratio of 0.5% and a 30-day yield around 9.5%. About 85% of the ETF’s portfolio is concentrated in financials. PowerShares Financial Preferred Portfolio, on the other hand, focuses exclusively on the financial sector.
Preferred shares have “been under extreme pressure and beaten down, so the yields are high,” said Ed McRedmond, senior VP of portfolio strategies at Invesco PowerShares. “Investors could be well-compensated for taking on that risk today.”
Meanwhile, some make the argument that the U.S. government investing in preferred shares and mortgage-backed securities cushions at least some of the risk. However, investors should be prepared for losses if more banks fail or there’s trouble at other large issuers of preferred stocks.
“Fears surrounding bank failures and a continued collapse of the mortgage market” cast doubt on preferred shares,” said Burns at Morningstar. “Although things have settled down quite a bit, this should serve as a reminder to any would-be investor that there is still a decent amount of risk.”
North Coast Investment Research 