Preferred-Stock ETFs Offer Plenty To Like

Investors navigate the oft confusing financial markets by relying upon their preferences. In no other investment is preference more exquisitely expressed than in preferred stock. Holders of preferred shares have priority over common shareholders with respect to dividend payments and claims to corporate assets upon liquidation. Preferred shares, known as “hybrid securities,” occupy a grey area in a company’s capital structure, with features of both equity and debt.

Because of their (generally) fixed dividend payments, preferred shares appeal to income investors, especially those in higher tax brackets. Dividends paid to preferred shareholders are higher than those earned on common stock and exceed, too, the interest received from many bonds. Like common stock, preferred shares can gain value if the issuing company fares well but can be highly sensitive to changes in interest rates.

The trouble with preferred shares is that it’s not easy to build a portfolio position with them. For one thing, not every company issues preferred stock. For those companies that do, the array of preferred equity offered—with their qualifications on dividends, convertibility and redemptions—can be bewildering. The market for preferred shares, too, is notoriously thin.

Enter preferred-stock exchange-traded funds (ETFs). On the scene for more than a decade, preferred ETFs offer immediate diversification and liquidity in just one trade. Most are plain vanilla funds that track an index±either broad or narrow in scope.

For most investors, an allocation to preferred shares properly comes from the fixed income side of their portfolios. Preferred equity is typically used as a diversifier, though many retirement-minded investors tend to think of it as a core allocation.

A half-dozen “seasoned” preferred-equity ETFs concentrate on the U.S. market. By “seasoned” we mean those with track records at least three years long. All provide dividend yields exceeding that of the Barclays Core U.S. Aggregate Bond ETF (NYSE Arca: AGG) and, in spite of their higher volatility, offer better risk-adjusted returns than the bond benchmark.

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Disclosure: Brad Zigler pens Wealthmanagement.com's Alternative Insights newsletter. Formerly, he headed up marketing and research for the Pacific Exchange's (now NYSE Arca) option ...

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