Public market investors generally invest in two types of securities: common stocks and bonds.

Common stocks represent ownership in the underlying company, accompanied by voting rights for issues of corporate importance. Bonds are debt instruments with a fixed coupon payment and predetermined maturity date. Companies issue bonds when they need to raise capital but do not wish to dilute their existing common stockholders.

Common stockholders have the most potential upside if a company performs well, but also the most downside if a company goes bankrupt.

Common stockholders receive liquidation payments in banktrupcy proceedings after bondholders do, which is one reason why stocks are viewed as more risky than bonds.

Most investors do not explore the third major type of financial instrument: preferred stocks. These securities are somewhere between common stocks and bonds and have characteristics similar to each in different ways.

Preferred shares have the potential for price appreciation (similar to common stock), but also have fixed dividend payments (similar to bond coupon payments). Preferred shares also have a higher claim on assets and earnings than common shares.

This article will provide a brief introduction to preferred stocks and compare their historical performance to domestic stocks, domestic bonds, and international stocks on both a nominal and risk-adjusted basis.

About Preferred Stocks

Preferred stocks are called ‘preferred‘ because of their seniority compared to common stocks when it comes to being paid back during a bankruptcy.

An investor will ideally not have to experience owning a company that declares bankruptcy. Fortunately, there are other benefits to owning preferred stocks.

Since preferred stocks are considered lower risk (and lower return) than common stocks, one would expect that they have lower volatility – and this tends to hold true in practice. By the same logic, preferred shares should (and do) have higher volatility than bonds.

Accordingly, preferred stocks can be used to lower the volatility of an equity investment portfolio. Preferred shares can also be perpetual, which means that they will be around as long as the company is. For fixed income investors, this presents an advantage over bonds because bonds have a fixed maturity date.

There are also downsides to preferred shares. For dividend growth investors, the main disadvantage to investing in preferred shares is that they have a fixed dividend payment. This downside is counteracted by the yield and safety of a preferred share dividend. Preferred stocks generally pay higher dividends than their common stock cousins. Further, a company in sound financial condition is highly unlikely to cut the dividend on its preferred share – which makes them a strong source of current portfolio income.

Investors looking for growing dividend income would be better off investing in the common stock of companies with proven histories of increasing their dividend payments. A fantastic group of such companies is the Dividend Aristocrats – companies with 25+ years of consecutive dividend increases.

The next section will explain the best way for an individual investor to add preferred shares to their portfolio.

Gaining Exposure to Preferred Stocks

Gaining exposure to common stocks is rather straightforward. Most companies have only one type of common stock outstanding, which means investors have no choice when making their purchases.

Rarely, some companies have two or more classes of stock outstanding. Berkshire Hathaway is an example of this, with its two types (Class A and Class B) of common stock.

Preferred stock investing is different because companies often have many different types of preferred shares. This introduces more complexity for investors.

Case-in-point: Wells Fargo (WFC) currently has 17 different preferred stock issues outstanding by my count, and even more if you include preferred stock issued in the name of separate trust entities (such as Wells Fargo Capital or Wachovia Capital).

While this might be a bit of an extreme example – banks tend to have very complicated capital structures – the point is that there are many more options to choose from when investing in preferred stocks.

Thus, one of the easiest ways for investors to gain exposure to preferred stocks is through exchange-traded funds (ETFs). ETFs are professionally managed investment funds that trade like stocks on exchanges.

A few of the largest preferred stock ETFs are listed below in the order of assets under management.

• iShares U.S. Preferred Stock ETF (PFF): $17.4 billion
• PowerShares Preferred Portfolio ETF (PGX): $4.8 billion
• First Trust Preferred Securities and Income ETF (FPE): $1.9 billion
• PowerShares Financial Preferred Portfolio ETF (PGF): $1.7 billion
• PowerShares Variable Rate Preferred Portfolio ETF (VRP): $1.3 billion

The prevalence of preferred stock in the capital structure of banks is evident in the list above – the PGF ETF specializes in owning the preferred stocks of financial companies alone, yet is the fourth largest preferred stock ETF as measured by assets under management.

For the rest of this article, I will be comparing the performance, volatility, and risk-adjusted returns against three other asset classes: domestic stocks, domestic bonds, and international stocks.

To proxy these asset classes, I will use the following ETFs (listed alongside their assets under management):

• Domestic Stocks: SPDR S&P 500 ETF (SPY): $212.0 billion
• Domestic Bonds: iShares Core U.S. Aggregate Bond ETF (AGG):$44.1 billion
• International Stocks: Vanguard FTSE All-World ex-US ETF (VEU) :$16.7 billion

Comparing Returns

Preferred shares offer promising total returns for investors. Generally speaking, the total returns of preferred stocks will be highly weighted towards dividend payments (compared to the weight of price appreciation for common stocks). This characteristic can be seen by looking at the dividend yields of preferred stock ETFs. The dividend yields of the 5 largest preferred stock ETFs is listed below.

Source: Yahoo! Finance

For context, the S&P 500 Index currently has a dividend yield of 2.0%.

Looking at total returns, preferred stocks have delivered satisfactory returns over most time periods. The past year has been particularly impressive with two of the preferred share ETFs delivering total returns above 10%.

Source: Yahoo! Finance

As expected, the performance of preferred stocks has lagged the performance of common stocks and beaten the performance of bonds over each of the time periods under consideration.

Preferred shares have also delivered returns above international stocks over the long run, which is impressive considering the higher volatility that comes from owning international stocks.

Source: Yahoo! Finance

Preferred stocks have performed exactly as one would expect in recent years – in between stocks and bonds.

However, risk-conscious investors are concerned with more than just absolute performance. High-volatility securities will always look like strong performers if the right time period is selected. That’s one reason why volatility is important.

The next section will compare the volatility of preferred shares to other financial instruments.

Comparing Volatility

Before conducting an analysis of the volatility of preferred stocks, I feel I must touch on the importance (or lack thereof) of volatility in investing.

Investors are generally divided when it comes to the importance of portfolio volatility.

On the one hand, volatility shouldn’t matter if an investor never sells their stocks. Day-to-day movements in stock prices have no effect on returns if one’s holding period is 5, 10 or 20 years.

Related: On Long-Term Systematic Investing

In practice, though, volatility should affect an investor’s portfolio management decisions.

There is empirical evidence that low-volatility stocks tend to outperform high volatility stocks (which would lead to fantastic risk-adjusted returns as measured by the Sharpe ratio).

This is why The 8 Rules of Dividend Investing ranks stocks by their long-term volatility and beta – because this metric has historically reduced risk and increased returns.

Volatility also allows investors to purchase stocks at a more attractive valuation if they view downward price movements as buying opportunities. I often think back to this quote from Michael Lewis‘ The Big Short, where he writes of hedge fund manager Michael Burry:

“[Burry] gave a talk in which he argued that the way they measured risk was completely idiotic. They measured risk by volatility: how much a stock or bond happened to have jumped around in the past few years. Real risk was not volatility; real risk was stupid investment decisions.

‘By and large,’ he later put it, ‘the wealthiest of the wealthy and their representatives have accepted that most managers are average, and the better ones are able to achieve average returns while exhibiting below-average volatility. By this logic a dollar selling for fifty cents one day, sixty cents the next day, and forty cents the next somehow becomes worth less than a dollar selling for fifty cents all three days. I would argue that the ability to buy at forty cents presents opportunity, not risk, and that the dollar is still worth a dollar.” (emphasis my own)

Related: How Uncertainty Helps Dividend Investors

With all that said, investors should be pleased by the low volatility of preferred stocks. Each of the five largest preferred stock ETFs has historical volatility numbers well below common stocks.

Source: Yahoo! Finance

Note: The 10-year volatility numbers are much higher than other time periods because preferred experienced large price fluctuations during the Great Recession of 2008-2009 as investors fled to safer asset classes.

The volatility of various asset classes is compared to preferred stocks in the following diagram.

Source: Yahoo! Finance

During all time periods (other than the 10-year, which is skewed by the financial crisis) preferred stocks had lower volatility than all financial instruments other than bonds. This is exactly what would be expected, given the characteristics of preferred stocks.

For investors looking for a low volatility alternative to preferred stocks that still offers strong total return potential, click here to see a list of the top 15 low volatility Dividend Aristocrats.

Comparing Risk-Adjusted Returns

Risk-adjusted returns (as measured by the Sharpe Ratio) allow investors to simultaneously assess performance and volatility. The Sharpe Ratio tells an investor how much additional performance is generated for each incremental unit of risk assumed.

The Sharpe Ratio is calculated as:

There is much debate over what is an appropriate metric to use for the risk-free rate of return. Given that interest rates are near zero right now, this analysis will use a risk-free rate of return of 0%. One could also use the 3-month t-bill yield which is currently below 1%.

As expected, preferred stocks have delivered excellent risk-adjusted returns. The Sharpe Ratios of the five largest preferred stock ETFs over various time periods is listed below.

Source: Yahoo! Finance

The Sharpe Ratios of preferred stocks is compared to domestic common stocks, domestic bonds, and international stocks in the following diagram.

Source: Yahoo! Finance

Judging from this data, preferred stocks appear to have the strongest risk-adjusted return potential of any asset class if we exclude the biased data from the Great Recession of 2008-2009.

Final Thoughts

Preferred stocks offer investors the opportunity to diversify away from typical common stock investments. They also offer lower volatility and fantastic risk-adjusted returns.