PFFA: Preferred stock ETF characterized by high return and high risk

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Virtus InfraCap U.S. Preferred Share ETF

Virtus InfraCap U.S. Preferred Share ETF (NYSEARCA:PFFA) is an exchange-traded fund (“ETF”) launched and managed by Virtus ETF Advisers LLC. It is co-managed by Infrastructure Capital Advisors, LLC (“ICA”). ICA is a registered investment adviser who manages 15 funds, including an actively managed ETF and a series of hedge funds. The firm was form in 2012 and is based in New York. Currently, Virtus has assets under management (“AUM”) of $1.29 billion.

Virtus InfraCap US Preferred Stock ETF was established on May 15, 2018 (nearly four years ago) and is domiciled in the United States. The fund has assets under management of less than $500 million, which it invests in the fixed income markets, primarily in preferred shares of US-based infrastructure-related companies. As a result, it generates a stable level of current income. It invests directly and through derivative instruments such as options. The fund seeks to benchmark against the S&P US Preferred Stock Index.

Preferred Securities – Is It Better Than Common Stocks and Bonds

Preferred shareholders have a priority at the time of the payment of the dividend compared to holders of ordinary shares. They also have a preference over the assets of the organization in the event of liquidation. Like bonds, preferred stocks provide investors with current income through dividends, which can be fixed or floating rate. Preferred shares also generally generate a higher return than equity shares. Preferred dividends, in some cases, are taxed at a lower rate for corporations. Dividends received by C corporations may be tax deductible when received from related entities.

For investors, preferred stocks have behaved more like bonds, as they are often rated by a rating agency. At the same time, like common stocks, preferred stocks are issued to retail investors and are traded on major stock exchanges. However, these stocks generally exhibit less volatility. Collectively, the preferred stock market has quadrupled since 2005 and is valued at approximately $1 trillion. But, despite market growth, preferred securities are often overlooked by traditional investors.

Preferred shares are less risky than equity shares because all payments to preferred shares are made before any payments to common stock holders. However, in the event of a loss, preferred dividends may be deferred or suspended, while interest payments to bondholders will continue as usual. The hybrid nature of preferred shares makes them unattractive to investors.

According to documents posted on the Virtus website:

“Given this carryover risk, the market is largely focused on quality companies, where cash flows are more stable and the probability of default is lower…… With interest rates rising, investors may be concerned about the potential impact on the price and yield of However, various characteristics of these securities can help moderate their sensitivity to changes in interest rates.

Most preferred stock is issued under a fixed-to-floating convertible payout option. According to documents posted on the Virtus website:

“a security can be issued with fixed coupons for a predefined number of years, usually five or 10 years, then converted into a floating rate coupon………The floating rate is fixed with a spread over a certain index of benchmark interest rate for the remaining life of the security or until called.

Composition of the PFFA portfolio and its benchmark index

Virtus InfraCap US Preferred Stock ETF has invested its fund in more than 150 preferred stocks, including preferred stocks of numerous unlisted companies. However, they are known to pay solid and regular dividends. Nearly 60% of the entire fund is invested in preferred stocks of 20 companies such as Crestwood Equity Partners LP (CEQP), RLJ Lodging Trust (RLJ), DCP Midstream, LP (DCP), Babcock & Wilcox Enterprises, Inc. .(BW), The Necessity Retail REIT, Inc. (RTL), NuStar Energy LP (NS), DigitalBridge Group, Inc. (DBRG), EPR Properties (EPR), New York Mortgage Trust, Inc. (NYMT), etc. .

PFFA’s stated benchmark, the S&P US Preferred Stock Index, measures the performance of the US preferred stock market. According to documents posted on the Virtus website:

“The index is calculated on a total return basis with dividends reinvested. The index is unmanaged, its returns do not reflect any fees, expenses or sales charges, and is not available for direct investment.”

However, PFFA has a very high expense ratio of 1.2%. This could make investing in Virtus InfraCap US Preferred Stock ETF unattractive to some extent.

Risks and Benefits of Investing in Preferred Shares

As Virtus InfraCap US Preferred Stock ETF invests in preferred stocks, it is able to generate stable current income in the form of dividends. The fund pays a regular monthly dividend. The current monthly payment is 0.1625 per share. Over the past four years, this ETF has generated an average return of almost 9%. With such high performance, the fund has been able to generate a total return of over 8% over the past four years. However, 2022 was poor in terms of return, as there is a price loss of almost 15% and the total return was negative.

Preferred shares are an effective strategic asset allocation tool. However, creating a preferred stock portfolio is not an easy task, as these stocks are not heavily traded. According to documents posted on the Virtus website, while investing in a portfolio comprised of preferred stocks, the ICA fund manager should:

“evaluate potential investment options on a variety of key variables, including a company’s competitive position; the company’s perceived ability to earn a high return on capital; the historical and projected stability and reliability of the company’s earnings; the company’s anticipated ability to generate cash in excess of its growth needs; and the company’s access to additional capital.”

In addition to this, ICA’s fund manager applied leverage to potentially improve portfolio exposure and used options strategies to generate additional current income. Opportunistic short positions are also used to hedge interest rate risk. However, short positions increase portfolio risk. Moreover, when a portfolio is leveraged, the value of its securities becomes more volatile. High inflation for 40 years, rising interest rates, a shortage of supply in the energy market, an impending recession and geopolitical turbulence make this portfolio even more risky.

Investment thesis

Investors can view preferred stocks as an income hybrid with the potential to diversify their fixed income portfolios, earn an attractive dividend yield, and manage interest rate risk in a rising rate environment. expected – overall a good tool to have in a strategic context. asset allocation. Over the past four years, through strong performance, the fund has been able to generate a total return of over 8%. So far, the fund has paid a regular monthly dividend. Thus, it is not a bad option for investors looking for income.

However, preferred stocks carry a deferral risk with respect to dividend income. With interest rates rising, investors may also be concerned about the potential impact on the price and yield of preferred shares. Additionally, short positions can increase portfolio risk. The leverage factor can also make the portfolio more volatile. On top of that, excessively high inflation, supply-side shortages in the energy market, and an impending recession make the Virtus InfraCap US Preferred Stock ETF a risky proposition.

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