While for most, pitting ETFs against active managers and their strategies long ago was decided in favor of ETFs, a conversation with William Scapell, manager of the Cohen & Steers’ Preferred Securities and Income Fund (CPXIX), an open-end mutual fund that has bested its three main ETF competitors, offers new ammunition for the active side.
The yield of CPXIX is very comparable to that of the big three preferred ETFs, he says: PFF, the iShares S&P US Preferred Stock Index; PGX, PowerShares Preferred Portfolio; and PGF, PowerShares Financial Preferred Portfolio. “But total return has been better,” Scapell notes. “If you compare my fund to these ETFs, the income is similar but depending on share class, total return — income plus price return — has been better.”
ETFs buy only a small portion of the market, Scapell contends. “They miss three-fourths of the investible universe of preferreds.” Preferred securities are a hybrid, with characteristics of debt and equity. For example, he explains, ETFs neglect the large amount of institutional securities traded over the counter. “This means they overlook better and cheaper securities in the OTC market.” While preferreds pay fixed rates of income, like corporate bonds, they are more deeply subordinated and therefore closer to equities than to corporate bonds. “Since they are higher in the capital stack, corporate bonds are safer than preferreds.”
JP Morgan pays 4.5 percent on its 10-year corporate bonds but its preferreds pay near 7 percent. “The typical high-yield issuer is smaller and more highly leveraged, but with preferreds, many issuers are the likes of JP Morgan, PNC and Met Life — large companies with very good credit ratings. With preferreds, the tradeoff for the higher income is greater subordination risk than you would have with bonds, so you would be more at risk if things go poorly. Yet, preferreds are above equities — equities would be wiped out before preferreds in a corporate liquidation.”
The investible universe for preferreds among actively managed funds also includes foreign currency, he continues. “Foreign currency denominated funds are useful for hedging and are cheaper, even hedged, than some U.S. currency denominated funds.”
Active management focuses on the fundamentals of companies and in Scapell’s case, he makes informed decisions about the credit quality of the issuers. “Especially given the recent credit crisis, since the majority of the issuers are banks and insurance companies, it’s vital to have a good understanding of the quality of each issuer. But ETFs typically buy securities without regard to the fundamentals of the companies in the index.” That’s why one of the preferred ETFs has gotten bitten by holding The National Bank of Greece preferreds, he says.
Writes Timothy Strauts in a report for Morningstar: European banks are a major part of the preferred stock ETFs, and they have serious exposure to the sovereign debt of these troubled European countries. Adds James Catledge, founder of The Catledge Companies: “The biggest risk that investors face is the European sovereign debt problem getting worse, so you’ll want to avoid Powershares Financial Preferred (PGF) with it 56 percent exposure to European banks. Our pick is iShares S&P U.S. Preferred Stock Index ETF (PFF) because of its lower European exposure and strong liquidity.”
Another factor to consider with preferreds in general: regulatory reform. “Dodd-Frank is going to have a profound impact on preferreds,” says Scapell. Preferred securities are a form of regulatory capital for banks, known as Tier I capital. “While many preferreds are perpetual, paying legal dividends and therefore are equity, trust preferreds are forms of debt. Post crisis, in Dodd-Frank, Congress said that trust preferreds didn’t act enough like equity. For instance, when the U.S. government injected capital to such financial institutions as Citi, the bank stopped paying on its equity and perpetual preferreds, but it continued to pay its trust preferred holders. Disappointed in the performance, the Dodd-Frank legislation calls for trust preferreds to lose their status as Tier I capital in the coming years.”
Per Dodd-Frank, in 2013, trust preferreds begin to lose regulatory Tier 1 credit and so go from the cheapest form of Tier 1 equity to simply the most expensive form of debt. “Issuers will likely buy them back, to call them away using provisions allowing them to do so, and some might be subject to tender and exchange offers,” Scapell explains. “You have to know the documentation, incentives and pricing well. But active managers can buy securities under par, for instance, and possibly realize capital gains as well as income if the issuer calls them away at par. Such passive investors as ETFs may miss many opportunities.”
He adds that it’s dangerous to own some securities over par, “but ETFs do. If the issuer takes out the security at par, exercising its rights to do this, as Fifth Third Bancorp of Cincinati, Ohio, did in May with its 8.875 percent instrument. Because ETFs own many above par securities, they’ll be losing the amount of capital above par.”
Scapell likes preferreds because they offer him many ways to create alpha: owning OTC shares, delving into the fundamentals of companies to find gems, paying attention to the complexities relating to preferred securities trading above par.
“We have been able to be defensive at the right times, like in 2009 when our institutional separate account strategy outperformed our ETF competitors by well over 1,000 basis points,” he continues. “We’re able to spend lots of intellectual capital, like now, taking advantage of companies buying back preferreds that will be losing Tier 1 status.”
He adds that although he uses models to scan securities valuations, “models are just models, you have to put your brain to them and understand company fundamentals as well as the macro picture. We use valuation models to get a picture of the landscape and take an active, research-driven approach to acting within that landscape.”
Scapell worked at the Federal Reserve in monetary policy and then moved to the treasury area of Merrill Lynch. “It was there that I saw how issuers looked at fixed income and preferred securities. I knew banks, monetary policy and fixed income, so I evolved into my current position,” he says. He’s been at Cohen & Steers for eight and a half years.
The Preferred Securities and Income Fund (CPXIX) year to date performance as of June 30 according to Bloomberg is 5.89 percent and for one year, 18.51 percent. This compares to PFF (iShares S&P US Preferred Stock Index) of 5.03 percent and 14.97 percent, respectively; PGX (PowerShares Preferred Portfolio) of 4.95 percent and 12.97 percent, respectively.
Briton Ryan, head of U.S. ETF sales and trading at Newedge, a joint venture between Societe Generale and Credit Agricole, says that investors in Cohen & Steers’ preferred fund would have to consider the management fee both before and after costs and decide how important liquidity is. “You have to wait until the end of each day to know your balance in a mutual fund, whereas with ETFs, you know your balance throughout the day.”
“Some mutual funds have lock-up periods,” Ryan continues, “which could be as much as two years in some cases, so it depends on market conditions whether you’d be willing to wait say six months, whatever the lock-up period is, before you can get at those assets.”
Preferred ETFs are transparent — you always know exactly what it is holding — what the underlying assets are, he continues.
Samuel Lee, ETF analyst at Morningstar, Inc., notes that preferred ETFs in general have been pretty popular, and the iShares PFF in particular, has had an extremely high yield.
Preferred Portfolio (Fund) is based on The BofA Merrill Lynch Core Fixed Rate Preferred Securities Index (Index). The fund normally invests at least 90 percent of its total assets in securities that comprise the index, which is designed to replicate the total return of a diversified group of investment-grade preferred securities.
