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Playing a Preferred Financial ETF

Roger Nusbaum

12/06/06 - 01:10 PM EST
PowerShares Capital Management just listed the PowerShares Financial Preferred Portfolio(PGF Quote).

Although it might be tough to say the name 10 times fast, the concept is simple to grasp: The exchange-traded fund owns preferred stocks from financial companies, both foreign and domestic, that all qualify for the 15% qualified tax rate.

I've lately received some questions and comments from readers regarding how to structure the fixed-income portion of a portfolio. Most investors have some allocation to fixed income but do not spend enough time managing it.

One part of the puzzle that I like and use for clients is preferred stock. Many preferreds are on the NYSE, so they are easy to trade, and the dynamics are such that they are individual-investor friendly.

Finding the credit ratings is easy to do, so you know what you are getting, and safe yields can be found around 6%.

While this might sound easy, there are do-it-yourselfers who are not comfortable picking individual preferreds. Those folks might have previously sought out a closed-end fund to invest in this segment, but I believe the ETF structure could be a better way to go.

The chart below compares the market price with the net asset value (NAV) for the Nuveen Quality Preferred Income Fund(JTP Quote), a closed-end fund.

As you can see, the market price has been much more volatile than the NAV as investors overreact to swings in interest rates in both directions.

The structure of an ETF takes this sort of divergence, and therefore probably the volatility, off the table. Most investors want a fixed-income product that does not move around a lot and just pays the income.

Nuveen Quality Preferred Income Fund
Market price vs. net asset value

The PowerShares ETF could be a better way to go. The fund currently has 24 holdings with MetLife Preferred B the largest holding, representing 8.46% of the fund, followed by HSBC Preferred A with a 7.96% weight and ING Preferred at 6.11%.

Those weights are larger than I might have thought. Stock selection for the fund mimics the Wachovia Hybrid and Preferred Securities Financial Index, whose methodology is proprietary.

You may notice that two of the three stocks listed are foreign; in fact, by my count, more than 70% of the fund is foreign. That is not really a problem as I see it, but it is worth noting that PGF has five different issues from Royal Bank of Scotland totaling 22%, ING has four issues totaling 17%, and Aegon is heavy with three issues weighing in, representing 11% of the fund.

While there is no reasonable probability that any of those companies will default, it is worth following what the fund owns and what changes get made in the future.

PowerShares expects the fund to yield in the mid-5% area after paying out a 0.6% fee. That yield would be reasonable, given that investors are having someone else pick stocks for them, but the 0.6% fee seems a tad high.

Accessing the fixed-income market for individual investors can be difficult, and the transparency of the ETF structure could make for an easier hold than other fund structures.

The other day, I asked for input from readers about what they would like to see in the way of new ETFs; fixed-income product is what readers want most. While PGF has its quirks, it provides access to a segment of the market that is not as easy to invest in as Treasuries, for which there are several ETFs.

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