Why Active Management Matters With Preferreds | ETF Trends

Investors’ affinity for preferred stocks is understandable. The asset class features less volatility and higher yields than common stocks and juicier yields than what investors get on many fixed income investments.

However, income seekers eager to access the advantages of preferreds may want to put active management on their side with the Principal Spectrum Preferred Securities Active ETF (CBOE: PREF).

Preferred stocks are a type of hybrid security that shows bond- and equity-like characteristics. The shares are issued by financial institutions, utilities, and telecom companies, among others. Within the securities hierarchy, preferreds are senior to common stocks but junior to corporate bonds. Additionally, preferred stocks issue dividends on a regular basis, but investors don’t usually enjoy capital appreciation on par with common shares.

“Investigating the universe of U.S. preferred-stock ETFs and mutual funds over the past 10 years, we can see that preferred stocks have underperformed U.S. equities (the S&P 500 index) and even underperformed U.S. long-term bonds. U.S. preferred-stock funds averaged an annual return of 7.29% over the period, compared with 7.70% for long-term bonds and 13.52% for the S&P 500,” reports Derek Horstmeyer for the Wall Street Journal.

Avoiding Disappointment

“Under normal circumstances, the fund invests at least 80% of its net assets, plus any borrowings for investment purposes, in preferred securities at the time of purchase,” according to Principal. “Examples of preferred securities include preferred stock, certain depositary receipts, and various types of junior subordinated debt (such debt generally includes the contractual ability to defer payment of interest without accelerating an immediate default event). It concentrates its investments (invests more than 25% of its net assets) in securities in one or more industries within the financial services sector.”

Like common stock, preferred stock is issued by a company and traded on an exchange. Preferred stock prices can fluctuate, but most of the returns from preferred stock come from dividends. Unlike common stock, preferred stock dividends are predetermined and paid at regular intervals. These dividends are paid in full before any dividends are released to common stockholders.

PREF can act as a portfolio diversification tool and reducer of correlations.

“Investigating the correlation of preferred-stock funds with the S&P 500 over the past 10 years shows that they are weakly positively correlated (correlation coefficient of 0.59). That means adding preferred equities to an all-equity portfolio might reduce overall risk a little bit,” according to the Journal.

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The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.