Investors often must accept a bit more risk to get more income out of their investments - often, but not always. Preferred stocks are one of a handful of high-yield exceptions to that norm.
Preferred stocks are in the middle of a company's capital structure, below debts like secured loans and bonds, but above common stocks. They're a little like common stocks in that they represent ownership in the company, but they pay a fixed rate like a bond that typically yields more than common shares.
That's what makes preferreds so interesting - they're less risky than common stocks while also yielding a bit more than 5% on average, says Jay Jacobs, Director of Research for ETF provider Global X.
Preferred stocks aren't easy to buy on their own. But over the past decade, mutual fund, exchange-traded fund and closed-end fund providers have launched numerous products - with different structures, strategies and costs - that make owning a group of these high-yield stocks easy. But investors have a few things to consider as they jump into this high-yield asset.
For one, expenses are a tricky point in this space. While most common-stock index funds are in a pricing race to the bottom, preferred-stock index funds haven't been nearly as aggressive about cutting fees. "In the passive space, where there's no intention to beat a benchmark, we still see a pretty wide dispersion in management fees," Jacobs says, adding that investors should "consider the fee disparities as they evaluate preferred ETFs."
And passive index funds aren't necessarily the only place to hunt for preferred stocks. Active funds can be a source of outperformance, though often at a higher cost. "Given that actively managed funds tend to be more expensive than passive ones, this ultimately means that active preferred funds have a high bar to clear to provide long-term value to their investors," Jacobs says.
To help investors select a strategy that's right for them, here's a look at 11 preferred stock funds - most of which yield between 5% and 7%.
Market value: $18.1 billion
Year-to-date total return: 7.8%
SEC yield: 5.3%*
Expenses: 0.47%, or $47 annually for every $10,000 invested
The biggest passive preferred stock fund out there - the iShares U.S. Preferred Stock ETF ( PFF , $38.37), which boasts more than $18 billion in net assets - has grown in popularity in recent years because of its nice yield and consistent returns. Over the past decade, PFF has delivered a 71% total return, with its dividend remaining mostly steady over that same time period.
The PFF has generated roughly 8% in total returns this year, though that pales in comparison to the 21% from the Standard & Poor's 500-stock index. That doesn't surprise Global X's Jay Jacobs, however. "Preferreds are senior on the capital structure to common stock and often have features that requirement the payment of their distributions ahead of common stock dividends," he says. "Therefore, we expect preferreds to outperform equities from the same issuer in a bear market, but underperform in a bull market."
The PFF itself is a broad bet on this asset class, holding about 290 preferred stocks across several sectors. It's heaviest in preferreds from financials (71%), with significant exposure to real estate (12%) too.
*SEC yield reflects the interest earned after deducting fund expenses for the most recent 30-day period and is a standard measure for bond and preferred-stock funds.
Market value: $5.5 billion
Year-to-date return: 10.7%
SEC yield: 5.5%
The PowerShares Preferred ETF ( PGX , $15.03), by Invesco ( IVZ ), is similar to PFF in many ways. PGX and PFF are both heavily invested in financials, which make up 73% of PGX's portfolio. Both boast a large number of holdings (PGX 264, PFF 292), and both have roughly 20% of their weight in the top 10 holdings.
The primary difference is credit quality. PFF's portfolio is 55% weighted in preferreds rated AAA - the highest credit rating from Standard & Poor's - with another 22% in preferred stocks that have earned other investment-grade ratings. The majority of PGX's holdings are investment-grade, too, but 65% of its portfolio is in BBB-rated bonds (the lower end of the scale), and just another 6% is in A-rated bonds. That helps provide a slight yield edge to PGX.
PowerShares' offering has had mixed results since its Jan. 31, 2008, inception. The fund did underperform PFF significantly through the bear market and early recovery. However, over the past five years, PowerShares' product has outperformed PFF 37.8% to 30.8% on a total return basis.
Market value: $518.6 million
Year-to-date return: 8.2%
SEC yield: 6%
If you're worried that PFF and PGX have too much exposure to financial companies, the VanEck Vectors Preferred Securities ex-Financials ETF ( PFXF , $19.86) may be up your alley. As the somewhat cumbersome name implies, this fund invests in preferred stocks of companies outside of the financial space.
There technically is a little financial-sector exposure via a 5% investment in insurance companies. But otherwise, PFXF lives up to its name, investing heavily in preferreds from real estate investment trusts (REITs, at 30% of net assets), electric utilities (25%) and telecoms (14%).
PFXF also sports lower credit quality than the previously mentioned pair of ETFs. Only 45% of the portfolio is invested in investment-grade preferreds (and most of that is in BBB-rated), with 16% dedicated to "junk"-rated preferreds, and 39% that aren't rated at all.
However, the strategy typically results in one of the biggest yields among preferred-stock ETFs, and its lower-than-average 0.41% expense means you get to keep more of the fund's returns.
Market value: $513.2 million
Year-to-date return: 20.3%
Distribution rate: 7.0%*
Let's turn to another group of funds that offer diversified preferred stock exposure: closed-end funds, or CEFs.
CEFs broadly have had a fantastic 2017, and the Flaherty & Crumrine Dynamic Preferred & Income Fund ( DFP , $26.71) - which is up more than 20% when including distributions - is no exception.
Flaherty & Crumrine is a small management firm, but one that focuses on preferred stocks and has built a group of funds that have beaten their benchmarks for decades. The DFP is a younger closed-end fund, but its 53% total returns since inception in 2013 are more than double the PFF's performance over the same time period.
DFP isn't a pure-play preferred fund - its mandate also allows it to invest in other income-producing securities (namely bonds) and even common stock. Still, its primary exposure is to preferred stocks, and it does so with a little geographic diversification - according to its most recent fact sheet, the fund was 75% in the U.S., with the rest spread among nine countries, including the U.K., France and Australia.
From a sector standpoint, financial company-issued securities make up the lion's share of the portfolio at 84%, with another 8% coming from the energy sector and 5% from utilities. That focus has helped DFP this year, as financial preferreds have climbed on the back of their issuers' healthier balance sheets.
*Distribution rate can be a combination of dividends, interest income, realized capital gains and return of capital, and is an annualized reflection of the most recent payout. Distribution rate is a standard measure for CEFs.
Market value: $912.9 million
Year-to-date return: 17.3%
Distribution rate: 6.9%
Flaherty & Crumrine believes this trend of preferred stocks benefitting from better credit scores among banks and financial firms - the largest issuer of preferred stocks - will continue.
"Preferreds have improved greatly from credit improvements," says Eric Chadwick, President of Flaherty & Crumrine. "The credit profile of banks has improved materially because of regulation since the financial crisis; that, combined with low rates, have meant preferreds have been a great place to be for credit quality and more yield than you can get in most other places."
That's why the Flaherty & Crumrine Preferred Securities Income Fund ( FFC , $20.64) has joined the DFP in enjoying a strong 2017. The FFC is a nearly pure-play fund, with 93% of its assets in preferred stocks, another 5.5% in corporate debt and the rest sprinkled in other categories. More than 75% of its assets are issued by banks and financial firms, and its top eight holdings are preferreds from big banks with a global presence.
FFC has been an outstanding performer in the past, boasting a 10-year annualized return of 12.6%, versus "just" 8% for the S&P 500 - a notable performance for a supposedly "sleepy" asset class.
Chadwick acknowledges that a rising-interest-rate environment could lower returns for some funds, but he doesn't believe declines will come anytime soon. "Preferreds may be a good coupon play in 2018," he says. "You won't see this year's total returns because a lot of that's already baked into the prices. That said, it's tough to find a fixed income product that offers you a better combination of credit quality and yield."
Market value: $214.4 million
Year-to-date return: 16.0%
Distribution rate: 7%
The Flaherty & Crumrine Total Return Fund ( FLC , $21.53) is a similarly prolific performer, outdoing the S&P 500 by 12.6%-8% annualized on a total-return basis. That's in large part because it's a mostly similar fund.
FLC, like FFC, has a 93% holding in preferreds, and more than three-quarters of its overall holdings are issued by banks and financial stocks. In fact, every sector weighting is within a percentage point of FFC. Credit ratings are similar, as are top holdings - preferreds from the likes of Metlife ( MET ), JPMorgan Chase ( JPM ) and PNC Financial Services ( PNC ).
The FLC does offer a slightly higher distribution rate at the moment. And while Total Return actually is trading at a nearly 2% discount to its net asset value, versus Preferred Securities' nearly 1% premium, FLC typically trades at a discount, while FFC typically trades at a premium.
So why the significant difference in expenses? Because of FLC's focus on total return, management can take a more active hand via strategies such as hedging for interest-rate hikes and using other derivatives - something FFC doesn't do. The more complex portfolio, then, translates into higher fees.
Market value: $752.6 million
Year-to-date return: 13.3%
Distribution rate: 7.2%
Cohen & Steers Limited Duration Preferred and Income Fund ( LDP , $26.04) is a pure-play fund that currently trades at a 4.5% discount to NAV - a deep discount considering it recently traded at par with its net asset value.
As "Limited Duration" would indicate, this fund's holdings have much shorter remaining maturities than some of the other CEFs listed here. For instance, 82% of FFC's holdings have a remaining maturity of 30 or more years, with another 15% that have 20 to 30 years left. LDP, on the other hand, has just 57% in the 20-30 and 30-plus categories combined, with 42% invested in securities with seven or fewer years remaining.
While shorter maturities can translate into lower yields, Cohen & Steer's fund clearly doesn't sacrifice anything on the distribution front.
One key to LDP's performance going forward - as well as many other preferred funds - is an improving economy driving corporate profits, which in turn should lift credit ratings, which should filter into better preferred stock prices. Kiplinger's GDP forecast for 2018 is for 2.6% growth, which is better than 2017's 2.2% pace, helping bolster the case here.
Market value: $801.7 million
Year-to-date return: 12.8%
Distribution rate: 7.1%
John Hancock Premium Dividend Fund's ( PDT , $16.60) has been a simply sensational fund over the past decade, returning more than 14% annually on a total-return basis - better than the S&P 500's 8% and the PFF's 5.6%.
That's in large part because this is very much a blended fund that uses preferred stocks and common stocks to balance exposure and boost returns as fund managers see fit. At the moment, 58% of the fund is invested in preferreds, with another 33% in U.S. common stock, 6% in foreign stock, 1% in bonds and the rest sprinkled among government debt, futures, swaps and cash.
John Hancock Premium Dividend Fund also stands out because, while it doesn't explicitly exclude financial companies from its portfolio, it's much less dependent on the sector than other funds in the space. Utilities such as Dominion Energy ( D ) lead sector weights at 43%, followed by financials at 32% and energy at 11%.
SEE ALSO: 30 Great Stocks of All Time
Market value: $8 billion
Year-to-date return: 10.8%
SEC yield: 3.4%
Minimum initial investment: None
The world of preferred stocks isn't limited to just ETFs - a few mutual funds invest in this asset, which means in some select cases, you may be able to get exposure to preferred stocks in your 401(k).
Cohen & Steers Preferred Securities and Income Fund ( CPXAX , $14.11), like many other preferred-stock funds, is heavy in the financial sector. A little more than half the portfolio is in banking preferreds, while 21% of its holdings were issued by insurers.
Where CPXAX stands out is its international diversification. Just less than half the fund is dedicated to American holdings, with the rest allocated to 15 other countries - mostly developed nations such as the United Kingdom (11%), Japan (7%) and France (6%). That filters into even its top holdings, including the likes of Dutch financial Rabobank Nederland and Canadian utility Emera.
There are big American holdings, too, such as preferreds from JPMorgan Chase and General Electric ( GE ). Yes, GE's common stock has taken a nearly 40% beating over the past six months as its financials deteriorated and the company cut its dividend - but its preferreds have declined only marginally, illustrating the low-vol nature of this asset class.
*CPXAX also has a maximum sales charge of 3.75%, but offers lower fees for higher investment amounts. Other share classes have different sales charges and annual expenses.
Market value: $851.8 million
Year-to-date return: 1.4%
SEC yield: 4.6%
Minimum initial investment: $2,500
The Salient Select Income Fund ( FFSLX , $22.43) is a rare bird in that it's a preferred-stock mutual fund that specifically targets the real estate sector.
This isn't a pure play - 68% of the weight is in preferreds, with 23% in equities and another 9% in cash - resulting in the lowest yield on this list, and the only one below 5%. But the REIT focus helps keep the fund's investment income higher than it would be with other industry concentrations. Moreover, the exposure to common stocks gives FFSLX an opportunity to enjoy brisker capital gains than pure preferred funds during upswings in the real estate sector, such as in 2016 and 2010.
Investors should note that almost 20% of the fund's holdings are tied to retail REITs - a particularly battered area of the sector thanks to the advances of Amazon.com ( AMZN ) against brick-and-mortar operators. However, there's also plenty of exposure to hotel, residential and mortgage REITs, among others. Top holdings at the moment include issues from Ashford Hospitality Prime ( AHP ), Colony Northstar ( CLNS ) and Chatham Lodging Trust ( CLDT ).
SEE ALSO: The 15 Best REITs for Retirement Income
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.