Markets

All ETF's are NOT Created Equal

I'm slow to adopt things. Eleven years ago, tired of the books stacked up on the nightstand, my wife gave me an Amazon Kindle (Nasdaq: AMZN ) for Christmas. It sat in the box for four months. Eventually, I came around. I haven't purchased a hard copy book since.

It took me awhile to incorporate exchange traded funds (ETF's) into my practice. In constructing portfolios, I still use individual stocks for my equity allocations. However, I have been gravitating toward ETF's in the fixed income space, primarily in preferred stocks.

Preferred stocks are a hybrid security that falls into the debt portion of a company's capital structure. Often, they are issued at $25 par face value per share and pay a higher dividend than the common stock. Preferreds are senior to the common stock but are junior to bonds and bank debt. There's usually a call feature allowing the issuer to redeem the preferred shares at their $25 face value. Lastly, they're usually exchange listed, giving them a liquid marketplace. Preferreds are popular among individual investors thanks to their availability, attractive yields and conservative profiles in comparison to a common stock.

As a professional investor, the challenge I've found in the current low yield environment is finding compelling preferreds trading at decent discounts to their par value. I don't pay premiums. Why pay $26 for something that is only worth $25?

That's when I started using ETF's in the preferred space. The benefits are obvious: no call date worry, proper diversification, etc. But which one or ones to use?

Here are some stats of three ETF's I have used in client portfolios.

Fund (Ticker) Price Yield Discount To 52 Week High
iShares U.S. Preferred Stock ETF (NYSE: PFF ) $38.94 5.78% 3.06%
PowerShares Preferred Portfolio (NYSE: PGX ) $14.89 5.84% 1.30%
Global X SuperIncome Preferred ETF (NYSE: SPFF ) $13.15 6.83% 10.60%

Which one did I end up using? Well, full disclosure, I've used all three. However, now I only use one. To determine which one, I had to be like an auto mechanic: roll up my sleeves and look under the hood of each one. Here's what I discovered.

Fund Financials Telecom Energy Materials
PFF 70.20% 3.72% 1.00% 0.87%
PGX 86.30% 4.39% 0.31% 0.12%
SPFF 73.51% 8.70% 2.64% 4.42%

Here's a partial breakdown of each fund's sector allocation. PGX is heavily weighted in financials (historically, big issuers of preferred securities). That's not the end of the world, providing the financial sector stays healthy going forward.

It also appears that both PGX and PFF may have reduced exposure in the energy and materials sector during the great commodities correction. Now, management or the benchmark may have mandated that move as prices on those particular securities were pummeled to going out of business levels. However, looks like SPFF hung on or added to those sectors. According to the fund's fact sheet, "SPFF invests in 50 of the highest yielding preferreds in the U.S. and Canada…" and is benchmarked to the S&P Enhanced Yield North American Preferred Index.

In the end, I chose SPFF. Here's why.

- PFF is too heavily allocated to financials. Big banks make up the bulk of that sector. The low interest rate regime and currently regulatory environment still has a ways to go and will continue to put pressure on financial company profitability. While preferreds are held for their yield, holders don't want to see issuers in distress. Although, SPFF has the second heaviest weighting in the sector, its telecom allocation is nearly double that of its peers giving investors attractive yield and exposure to a true growth sector.

- SPFF's heavier weighting in energy and materials give investors an opportunity to take advantage of a deeply discounted sector while getting paid.

- PFF and PGX shares are nearly fairly valued relative to their 52 week highs. SPFF trades at an attractive discount to its 52 week high again giving investors the potential for gains.

- SPFF yields 17% more than PFF and PGX picking up 100 basis points (bps). Any opportunity for a 100 bps pick up in yield should always be evaluated.

Risks To Consider: Companies issuing preferred stock aren't always obligated to pay out preferred dividends. Preferreds are issued as either cumulative or non-cumulative. Cumulative preferreds have a provision that requires dividends to accrue should management decide to suspend both common and preferred dividends. Non-cumulative preferreds don't have this accrual protection. However, SPFF offers enough diversification to offset that risk.

Action To Take: SPFF shares trade at an attractive discount compared to other preferred stock ETF's and offer superior yield paid on a monthly basis. Moderate investors looking for value and above average income should look at adding a position in SPFF to portfolios. Those who currently hold PGX or PFF should consider switching to SPFF as their preferred stock ETF allocation.

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Disclosure: Adam Fischbaum owns shares of SPFF in client portfolios.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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