Preferred ETFs Are Pushing The Limits

I recently wrote an article about several different preferred stock ETFs and how they can be implemented into your portfolio to as a source of income and capital appreciation. However, with the continued rise in the stock market over the last six weeks I wanted to revisit this topic to analyze the potential volatility that these funds can be susceptible to as well. I believe that it is becoming increasingly important to have a game plan in place to manage the risk of falling asset prices in your portfolio as we move into the seasonally weak summer months.

Income investors have been conditioned by Ben Bernanke and the Federal Reserve to seek out higher yielding securities for their capital in an effort to generate an adequate dividend stream. This has injected billions of dollars into preferred stocks, junk bonds, mortgage REITs, and other high yield investments. The continued barrage of asset flows has created a very steady lift for these securities that has masked the potential pitfalls of a swift correction. That correction could come in the form of a stock sell off, interest rate rise, or other unforeseen event.

The chart below of the iShares U.S. Preferred Stock ETF (PFF) shows just how serene the last 12 months have been. Investors in this ETF have been steadily collecting their 5-6% yield as the price has risen with barely a blip of potential trouble. This type of low volatility is almost similar to what you are accustomed to seeing with a diversified bond fund.

However, a longer term chart tells a much different story. You can see back in July 2011 the fund fell over 10% in a very short period of time which coincided with similar volatility in the SPDR S&P 500 (SPY). Investors that weathered that storm were ultimately rewarded with further capital appreciation. However, with the risk of looming interest rates, I am not convinced that the next correction will react in the same fashion.

How to Manage the Risk of Your Preferred Stock ETFs

With a high yield bond position you have the option to choose a fund with a lower duration or higher credit quality to guard against a sell off. Unfortunately with preferred stock funds, that option does not exist. Therefore investors in this sector need to be savvy in positioning their asset allocation and risk tolerance to take advantage of the current low volatility.

If you have a highly appreciated position in PFF or another similar preferred stock fund, you may want to consider selling a portion of it into strength to lower your exposure. That way you can still participate in the upside of this sector but don’t have the same risk characteristics if stocks start to slide. In addition, you may ultimately be able to use the cash from this sale to purchase the fund back at lower prices or pair it with a different income generating ETF.

You can also consider diversifying your exposure to another position such as the actively managed First Trust Preferred Securities and Income ETF (FPE). While this fund is new and untested, it is on my watch list as a potential alternative for my income clients if the fund managers can prove to add alpha over their passively managed peers.

It is important not to become complacent with the current state of the markets and continually monitoring both risks and opportunities to safely generate the income that you desire.

Disclosure: David Fabian, Fabian Capital Management, and/or its clients may hold positions in the ETFs and mutual funds mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities.