While I like the defensive nature of preferred shares, with their priority claim in the capital structure compared to common shareholders, I am concerned that the typical preferred share fund like the Global X U.S. Preferred ETF (PFFD) is overly concentrated in the Financials sector. This exposes the fund to elevated risk, especially during periodic financial crises like the regional bank crisis we saw in March.
In my search for a better preferred share fund, I came across the VanEck Preferred Securities ex Financials ETF (NYSEARCA:PFXF). The PFXF ETF only tracks the investment returns of preferred shares issued by non-financial companies. This provides better diversification compared to PFFD.
The result is better long-term returns for the PFXF ETF, with 3 and 5Yr average annual returns of 5.0% and 3.8% compared to -0.6% and 1.1% for PFFD. PFXF’s better performance does not come at the expense of lower distribution yields, as the PFXF and PFFD have similar distribution yields above 6%.
Overall, I think the PFXF ETF may be a better investment vehicle for income oriented investors who want exposure to the preferred share asset class.
Fund Overview
The VanEck Preferred Securities ex Financials ETF provides exposure to a broad basket of preferred stocks in the U.S. outside of the Financials sector. The PFXF ETF tracks the ICE Exchange-Listed Fixed & Adjustable Rate Non-Financial Preferred Securities Index (“PFAN Index”), an index designed to measure the performance of the U.S. listed hybrid debt, preferred stock, and convertible preferred stock issued by non-financial corporations. By excluding financial companies, which dominate the broad-based preferred security indices, the resulting index may deliver greater sector diversification.
The PFXF ETF has $1.18 billion in assets and charges a 0.40% expense ratio (Figure 1).
Figure 1 – PFXF fund overview (vaneck.com)
Portfolio Holdings
Figure 2 shows PFXF’s sector allocation. As designed, the PFXF ETF avoids preferred securities issued by financial companies. The largest sector weight for PFXF is Electric Utilities (28.9%), followed by REITs (21.3%), Telecommunications (13.4%), Multi-Line Utilities (8.1%) and Oil & Gas Equipment (4.7%).
Figure 2 – PFXF sector allocation (vaneck.com)
Figure 3 shows PFXF’s credit quality allocation. PFXF’s portfolio is about 1/3 investment grade rated, 1/3 non-investment grade, and 1/3 unrated.
Figure 3 – PFXF credit quality allocation (vaneck.com)
Returns
Figure 4 shows PFXF’s historical returns. PFXF had an atypically poor 2022, with the fund returning -19.2%. However, even with poor 2022 returns, the PFXF ETF has delivered modest long-term returns with 3/5/10Yr average annual returns of 5.0%/3.8%/4.7% respectively to June 30, 2023.
Figure 4 – PFXF historical returns (morningstar.com)
PFFD’s poor 2022 returns are most likely caused by its holdings of fixed coupon preferreds, which act like bonds. In 2022, bonds suffered steep drawdowns as the Federal Reserve increased interest rates in order to combat inflation.
While the PFXF’s portfolio duration measure is not disclosed, we do know that approximately 75% of the portfolio has maturity greater than 30 years. Hence the portfolio’s duration may be commensurately high (Figure 5).
Figure 5 – PFXF maturity profile (vaneck.com)
For comparison, the iShares 7-10 Year Treasury Bond ETF (IEF) with an effective duration of 7.6 years, lost 15.2% in 2022. So I estimate PFXF’s portfolio duration is likely larger than IEF’s 7.6 years.
Distribution & Yield
PFXF pays a generous monthly distribution, with trailing 12 month distribution of $1.05 / share or 6.1% (Figure 6).
Figure 6 – PFXF distribution (Seeking Alpha)
PFXF’s distribution is not fixed but depends on the yield of the underlying securities. The underlying portfolio currently has a 30 Day SEC yield of 6.9%.
PFXF vs. PFFD
A few months ago, I provided an update on another preferred share-focused ETF, the Global X U.S. Preferred ETF (“PFFD”). How does PFXF compare to PFFD?
In terms of fund construction, I was cautious on the PFFD ETF because of its heavy Financial sector exposure. With an ongoing regional banking crisis due to elevated short-term interest rates pressuring deposits, I believed the PFFD ETF would continue to see headwinds. However, the PFXF ETF excludes Financials preferred shares, so portfolio holdings-wise, I prefer the PFXF at this time.
Coming to performance, the PFXF ETF has certainly performed better in 2023 YTD, as it did not have to contend with the regional bank headwind. However, even on longer-term returns, the PFXF is superior, as it has delivered 3/5/10Yr average annual returns of 5.0%/3.8%/4.7% to June 30, 2023, compared to -0.6%/1.1% for the PFFD ETF on 3/5Yr average annual returns (Figure 7).
Figure 7 – PFFD historical returns (morningstar.com)
Finally, in terms of distribution, the PFFD ETF pays a trailing 6.6% distribution yield vs. 6.1% for PFXF, so the two are comparable.
Overall, I prefer the PFXF ETF due to its better diversified portfolio that is able to deliver modest mid-single digit returns over the long-term.
Risks To PFXF
Of course, the PFXF ETF is not without risks. As mentioned above, preferred securities share similarities to bonds and often trade on the same macro drivers as bonds. For example, in 2022, when interest rates rose, fixed coupon preferred securities lost value due to duration losses. If interest rates were to continue rising, especially long-term interest rates, then the fixed coupon preferred securities held in PFXF’s portfolio will continue to suffer.
Another risk to preferred securities is credit risk. Although PFXF is more diversified as it avoids the heavy concentration in the financial sector, PFXF’s portfolio will still be impacted when credit spreads widen. For example, historically, we can see PFXF’s NAV typically plunges when high yield credit spreads spike higher (Figure 8).
Figure 8 – PFXF’s NAV declines when credit spreads widen (Author created with price chart from stockcharts.com)
If the economy were to weaken and credit spreads spike higher, then investors should expect PFXF’s NAV to decline.
Conclusion
The VanEck Preferred Securities ex Financials ETF provides exposure to preferred shares of non-financial companies. Since preferred security indices are dominated by financial company issuances, the PFXF ETF may provide better diversification than the broad indices.
Even with an atypically poor 2022 performance due to duration losses, the PFXF ETF has delivered modest long-term returns with 10Yr average annual returns of 4.7% to June 30, 2023. This backstops a generous monthly distribution currently yielding 6.1%.
I believe the PFXF may be a solid alternative for income-oriented investors who want to own preferred shares. The PFXF ETF is more diversified than the typical passive ETF like PFFD which has high financial sector concentration that can ‘blow up’ during financial crises.
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