Preferred Customer: ETF Makes Elite Stocks Open For Everyone

By Brian O’Connell

If you’re rich enough – or otherwise have access to your local private country club’s locker room – sooner or later you’ll hear a pair of wealthy golfers discussing their preferred stock holdings.

It’s a sad fact that you usually find preferred stockholders in elite enclaves – think the country club locker room, the corner table at Elaine’s, or in the box seats at Yankee Stadium.

“Preferred” stocks are Wall Street’s way of saying some investors are better than others.  It’s a big market – Standard & Poor’s estimates the size of the U.S. preferred stock market at about $214 billion – that’s quadruple the amount back in 1993.

Preferred stock ETFs are especially popular (more on that topic in a moment).  A particular favorite is the iShares S&P U.S Preferred Stock Index Fund, which returned 14% in 2010, has almost tripled in size to $8 billion.

In a word, preferred stocks are high on Wall Street’s securities pecking order, right there above common stocks and below bonds (the highest-rated security in a company’s capital structure). Such stocks offer investors additional rights and privileges above and beyond those of commons ticks.

That means many things; most of them good for preferred stock investors. Here’s a quick list of benefits:

The following features are usually associated with preferred stock:

  • “Preferred,” means getting first preference when dividends are doled out to shareholders.
  • “Preferred” also means being first in line for company assets in the event of liquidation.
  • Preferred shares can be converted into common stock – but not vice-versa.
  • Yields are higher with preferred stock compared to other securities. The Wall Street Journal pegs average annual yields on preferred stocks at 7%.

If you’re still on the fence, ask investment legend Warren Buffett about the advantages of preferred stocks. Right smack in the middle of the economic meltdown in 2008, Buffett bought $5 million worth of preferred share stock from embattled financial giant Goldman Sachs (Stock Quote: GS). Goldman needed the capital and was willing to pay handsomely for it. Buffett got a 10% yield on his preferred stock investment – meaning that as long as Buffett hangs on to his shares, he’ll earn $500 million each year in dividend payments.

Risk Versus Reward: Benefits of Preferred Stock ETFs

But preferred stocks come at a higher price than common stock, and with more risk than bonds.

Companies can shut off preferred stock dividends at any time. That’s exactly what happened to investors at Fannie Mae and Freddie Mac in immediate aftermath of the economic meltdown of 2008. Many banks cut preferred investors out of the dividend loop during that time, and the Standard & Poor’s U.S. preferred-stock index fell roughly 26% in September 2008, three times worse than “junk” bonds.

So how can you cut your risk, but still benefit from preferred stocks? Step right up, preferred stock exchange traded funds (ETFs).

Preferred stock ETFs are the great equalizer among investors. These ETFs enable any investor to buy into the benefits of preferred shares, but at a much lower price, and at a much lower risk level.

What are some of the big advantages of preferred stock ETFs. Let’s start with these examples:

  • Monthly dividends – Many preferred share ETFs pay dividends monthly. That allows ETF investors to put that money right back to work quickly, and further beef up their investment portfolios. Or, in the case of a retiree, the monthly dividend can help pay down household budget needs.
  • You’re ahead of common stock shareholders – Dividends for preferred stocks, including preferred stock ETFs, get paid before any dividends are paid to common stock shareholders.
  • Less volatility – Preferred stock ETFs are usually subject to lower volatility risk than the owner of the same company’s common stock. Historically and structurally, preferred stock ETFs don’t ebb and flow as much as common stocks and thus prove to be a more stable investment.

Of course, not all investments – nor preferred stock ETFs – are foolproof. Here are some risks associated with ETFs.

  • Volatility risk – On the downside risk with preferred stock ETFs, volatility can work against ETF investors. In fact, not all preferred stock ETFS perform the same, because they all don’t have the same holdings. Some ETFs are heavily weighted toward financials stocks; others are weighted across various industries (we’ve included a break down of popular ETFs below). When you invest in preferred stock ETFs, make sure you know what stocks they hold first.
  • Interest rate risk – Share prices can dive with preferred stock ETFs when interest rates rise. That hasn’t happened yet in 2011 (actually, rates have declined, sending preferred shares higher). But if the Federal Reserve does hike rates, expect high-yield investments like preferred stock ETFs to slide in share price, as more investors abandon equities and head toward higher-rate bond instruments, like U.S. Treasuries.
  • Annual fees – Like most ETFs, preferred share ETFS charge fees, although such fees are nowhere near the fees charged by most actively-managed mutual funds. Expect an annual fee in the 0.50%-to-0.75% range.

The number of preferred stock ETFs is burgeoning, as investor demand pushes more ETFs out into the marketplace. What are some of the tops preferred ETFs you should consider? has accumulated a worthwhile list:

  • SPDR Wells Fargo Preferred Stock ETF (Stock Quote: PSK): The Wells Fargo ETF is one of the newest preferred share ETFs – it launched in September, 2009. Essentially, the ETF mirrors the Wells Fargo Hybrid and Preferred Securities Aggregate Index. In risk-adjusted returns, PSK has delivered in spades, returning almost 47% over the past year.
  • iShares S&P U.S. Preferred Stock Index Fund (Stock Quote: PFF): The S&P ETF is another big-return vehicle, averaging 40.0% in one-year returns. The S&P fund is one of the largest preferred stock ETFs, with $7.45 billion in assets. The fund tracks the  S&P U.S. Preferred Stock Index, which is weighted fairly heavily in financial stocks.
  • PowerShares Financial Preferred Stock Portfolio (Stock Quote: PGF): The Powershares ETF is comprised of 100% financial industry stocks, essentially tracking the Wachovia Hybrid % Preferred Securities Financial Index. The fund returned over 18.0% over the past year.

If you’re looking for steady income, decent yields, and some protection against capital risk, preferred stock ETFs could be the real deal for you.

As always, protect yourself first by thoroughly examining any ETF that’s on your shopping list. Check for the stocks included in the portfolio, and look closely at the fund’s dividend payment history.

Past that, preferred stock ETFs are hot right now – and certainly deserve a closer look from value conscious investors.