Are Index Funds the Best Way to Own Preferred Stocks?

Investors could have held just about any hodgepodge of preferred stocks and still made money over the last few years.

The S&P US Preferred Stock Index returned a cumulative 25.4% over the three years ending October 31, more than doubling the 10.8% cumulative return offered by bonds as measured by the Bloomberg Barclays US Aggregate Bond Index.

Yield-hungry investors helped drive these returns by pouring money into preferred stock index funds. Preferred stocks were the most popular fixed-income asset class in 2015 in terms of relative exchange-traded fund (ETF) inflows, and are on track to repeat that feat in 2016 thanks to a record $5.6 billion of inflows through the end of August, according to a recent research note by Simon Colvin at IHS Markit.

Large amounts of capital haphazardly chasing a narrow asset class should alarm any value-conscious investor. Moreover, the diversification investors expect from owning an index fund is muted by the high industry and issuer concentration found in preferred stock indices. As of the end of October, roughly 73% of the constituents in the S&P US Preferred Stock Index were classified as financials, and the same large US bank issued three of the top 10 constituents.

Going forward, investors may want to consider a more selective approach. Here are a few examples of how they might try to add value over a preferred stock index fund:

Non-Listed Preferreds

Preferred stocks trade on either major exchanges, such as the NYSE, or in the over-the-counter (OTC) market. Many large banks have numerous similar but distinct types of preferred issues outstanding, and some of these trade only in the OTC market.

Preferred stock index fund investors may not know they are missing out on a large part of the market. Research by Cohen & Steers asserts that preferreds traded in the OTC market make up more than half of the US dollar-denominated preferred stock market. In contrast, most widely followed preferred stock market indices, and the popular ETFs that seek to track them, omit preferred stocks traded in the OTC market. This may create a relative opportunity for investors.

Preferred stocks that trade in the OTC market aren’t followed so closely by retail investors and sport valuations that are less likely to be distorted by large ETF inflows. In addition, they generally have less interest rate-sensitive structures, such as fixed-to-floating dividend payments, which is attractive to investors concerned about rising interest rates.

On the downside, non-listed preferreds generally have larger par values, often $1,000 per share, and tend to be less liquid than the preferreds listed on major exchanges. For the average investor, this can make it both more difficult and more costly to purchase them directly.

Managing Call Risk

Investors in preferred stock index funds may be blindly exposed to the risk that many preferred shares could be called away at lower prices, leading to reinvestment risk and creating a potential drag on index fund returns.

More than a quarter of holdings in the largest preferred stock ETF are callable by the end of the year, accordng to reports. Furthermore, in his article, Wall Street Journal columnist Jason Zweig notes that “normally the market anticipates an issue will be called and gradually adjusts its price downward. But so much money has rushed in that prices have gotten out of whack. Some preferred issues are trading at premiums that may hand investors sudden losses.”

With many preferreds becoming callable in the near future, managing call risk should be a high priority. Investors who examine preferreds on a case-by-case basis, rather than at an index level, will be far better able to manage this risk.

Tax Efficiency

Preferred stock dividends are often touted for their tax advantages over the interest payments offered by bonds. But not all preferreds pay dividends that qualify for preferential tax treatment.

Funds that seek to closely mimic preferred stock market indices often hold preferreds that pay non-qualified dividends, such as trust preferreds and those issued by real estate investment trusts (REITs). In fact, around 32% of the dividend income paid out by the largest preferred stock ETF in 2015 did not qualify for preferential tax rates.

Tax-sensitive investors holding preferred stock index funds may not be getting the best bang for their buck. These investors can boost their after-tax returns by avoiding preferreds that do not pay qualified dividends.

Conclusion

Preferred stock index funds are a double-edged sword. They are a simple, liquid, and low-cost way for investors to gain exposure to preferreds, but their simplicity makes them a blunt tool and harbors risks that have become more intense after record investor inflows.

Now is a good time for investors to reevaluate the “why” and “how” behind the decision to own preferreds. Investment advisers can add value by helping clients weigh investment risks and their unique constraints when making this decision. Investors in a low tax bracket with smaller amounts to invest, a lower tolerance for liquidity risk, and a higher tolerance for interest rate risk may want to consider an index fund. Conversely, tax sensitive investors with larger portfolios, a higher tolerance for liquidity risk, and a lower tolerance for interest rate risk might benefit from a more selective approach to investing in preferreds.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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