ETF Watch: PGF

I inherited a portfolio that contained the PGF. At first blush, the PGF looks great: it has a 9% yield. Pundits like Cramer love it. But let’s get serious and do some homework.

The ETF. So if you look up the PGF (http://www.invescopowershares.com/products/overview.aspx?ticker=PGF), it's the PowerShares Financial Preferred Portfolio. It’s a fund based on Wachovia’s Hybrid & Preferred Securities Financial Index (WHPS Financial Index). You can’t invest in an index, so the PGF seeks to track the WHPS Index. The fund will invest at least 90% of its total assets in securities that are in the base index.

Fund Holdings. So the first obvious question is, what’s in this thing? When you go to the product homepage (above), there’s a little link that says “Fund Holdings”. That takes you to this page: http://www.invescopowershares.com/products/holdings.aspx?ticker=PGF. You’ll see that as of 1/12/2010, there were 39 holdings and the top holdings were Bank of America, Barclays, ING, Wells Fargo and JP Morgan Chase preferreds. Looking over the list, there’s a few banks whose financial condition I’m not familiar with, such as AEGON, ING and REPSOL; and many banks that I’m comfortable with, such as BAC, Barclays, Wells Fargo, JP morgan, HSBC, Credit Suisse, Goldman Sachs, Santander and Prudential. There’s a couple holdings whose stock I wouldn’t buy – Royal Bank of Scotland and National Bank of Greece.

Overall, I’m fine with the holdings because I believe that the worst of the financial crisis is over. There could still be problems this year, particularly this summer. But in the long-term, we’re on an uptrend in financials. While I wouldn’t buy Royal Bank of Scotland and National Bank of Greece, I don’t think they’re going under.

Fund Yield, Price and Expenses. Other key facts include a 30-day yield of 7.59% and a 12-month yield of 8.39%. It trades at $17.12 and has an expense ratio of 0.68%, a bit high but much lower than a mutual fund.

Risks. So let’s look at the risks and downsides. First, let’s start with the equity risk. The PGF is comprised of financials (as the name implies). Critics say that you would be getting a 8-9% yield but would be risking a 100% loss. Still, as mentioned, I believe the worst of the financial crisis is over. We may still have a dip in the medium-term, but in the longer-term, we’re on an uptrend as the recovery continues. In my opinion, the biggest risk is a dip in the medium-term as latent financial problems (e.g., foreclosures) surface.

Later, banks could also take a hit when the yield curve flattens. Longer-term rates will rise. Because banks borrow short and lend long, this will, at first, help banks. But eventually the Fed will raise short-term rates, causing the yield curve to flatten. This will lead to lower margins for banks. This is something to watch out for, particularly toward the end of the year

Second, let’s look at the preferred security itself. Preferred stock has a fixed dividend, and that makes it vulnerable to interest rates. So when interest rates rise, new securities are a better investment because they offer a higher rate of return than existing preferred. This would imply that the price of the preferred stock would fall. On the other hand, banks perform better with a steeper yield curve, and that could increase the value of the preferreds. So the impact on the PGF itself is unclear. More than likely, the PGF will have to sell off declining securities and reinvest in newer securities, leading to some losses in the fund. Truth be told, all this is theoretical at this point. We will have to see what happens when rates rise, be vigilant and be prepared to exit if the value drops significantly.

Eventually, the yield on preferred stock will drop. An 8.5% to 9.0% yield is a reflection of our times, when financial stocks are worth less than they are in “normal” times with normalized earnings. Another factor to watch out for in the longer term.

Other Considerations. So here are some other pluses and minuses of preferred stocks:

- Preferred shares are higher in the capital structure than common stock

- Dividends must be paid to preferred stock owners before being paid to common stock holders

- Dividends are fixed

- Preferred stock holders have no voting rights

- Because preferred shares have debt characteristics (fixed dividend, like a bond), they also have less potential for share price appreciation

- Many preferred shares dividends are qualified dividends taxed at 15%, unlike bond income, which is taxed at regular rates. The tax treatment of dividends may change the coming years.

Managing the Investment. Tom Lydon, an ETF guru and author of the ETF trend Playbook, has three rules for managing ETF investments:

- maintain an 8% stop loss on ETFs

- if the ETF falls below the 50-day moving average, that’s a red flag. If it falls below the 200-day moving average, then sell

- don’t chase markets that are too hot, such as in 2000.

He also says that you should only invest in ETFs trading above their 200-day moving averages. If you look at a chart of the S&P since 1994, it was best to stay out of the market when the S&P traded below it’s 200-day moving average.

Here’s an example of applying one of his guidelines. If you buy an ETF trading 15% above its 200-day moving average, then you should have an 8% stop loss.

Interestingly enough, these guidelines could apply to more than just ETFs. Not a bad set of guidelines to work with.

Other ETFs. So the PGF isn’t the only preferred game in town. There’s the iShares S&P U.S. Preferred Stock Index (PFF), created in March 2007. As the name implies, this tracks the S&P U.S. Preferred Stock Index. It invests at least 90% of assets in securities that comprise the index, which includes stocks listed on the NYSE, AMEX or NASDAQ. Companies have a market cap of at least $100 million and the fund is non-diversified. The PFF’s expense ratio is 0.48%, a low turnover of 12% and the yield is about 8.58%. Currently, it trades at $37.63.

There’s also the PowerShares Preferred (PGX), which seeks to track the Merrill Lynch Fixed Rate Preferred Securities Index, established in January 2008. At least 80% of total assets are invested in the Merrill Lynch Preferred Index. The expense ratio is 0.5%, it has a high turnover of 52% and its current yield is 8.09%. As of today, it trades at $13.68.

Conclusion. Generally, I like the preferred stock ETFs at this point in time. There’s some risk that prices may fall after this point, but eventually, in the longer-term, prices should rise as we get closer to normalized earnings. At that point, yields will fall, so it will have to be re-evaluated as an investment. In the meantime, I will be holding on to the PGF in the portfolio I’m managing. And of course, watching out for the risks outlined above.