One Way to Play the Financial Sector

June was another brutal month for the financial sector. To highlight some of the carnage: Lehman Brothers LEH reported a quarterly loss, shook up its management team, and issued $6 billion worth of dilutive equity. Also, Goldman Sachs GS reported that losses on credit-related products weighed on its quarterly earnings, and American International Group's AIG CEO was yet another chief who received his walking papers as the result of the current credit mess. More bad news is almost sure to follow in the near term, so it's easy to understand why some investors are running away from anything related to the troubled sector.

However, some investors (including us) believe that many companies in the financials field are undervalued in the long term. These investors, or anyone else who is looking for exposure to financials, might be interested in PowerShares Financial Preferred Portfolio PGF.

PowerShares Financial Preferred Portfolio aims to mirror the results of the Wachovia Hybrid & Preferred Securities Financial Index (WHPS Financial Index) before fees and expenses. The WHPS Financial Index is a market-cap-weighted index created to track the results of certain preferred securities issued in the United States by financial institutions.

So why are we pointing out this fund? The most obvious reason is because it looks cheap. As of this writing, it is currently yielding 8.3%, easily trouncing the yields offered up by iShares S&P 500 Index IVV, other financial-sector ETFs such as Financial Select Sector SPDR XLF, and even the 10-year Treasury note.

But besides its current valuation, we think it's a compelling investment opportunity due to the characteristics of its underlying preferred securities. Most investors are quite familiar with investments in companies' debt securities, including bonds and common stock. However, preferred securities, a hybrid issue with characteristics of both debt and equity (and advantages and disadvantages over both), are less known or understood.

Preferred stock is similar to many forms of debt in that it typically provides periodic payments to investors (in the form of dividends) at a stated fixed-rate percentage of its fixed par value, much like a bond's periodic coupon payment. What's significant is that this fund consists of securities whose dividends are "qualified dividend income" eligible. As a result, these preferreds' dividends are taxed at a maximum tax rate of 15%, similar to the rate applied to common stocks' dividends, instead of the typically higher, ordinary rate.PAGEBREAK

Preferred stock also sports certain advantages over common stock. Hands down, the payment priority that preferred stock has over common stock is the most important. Holders of preferred securities receive their dividend payments before holders of common stock receive theirs. Also, if preferred dividends aren't paid to holders when they are due for whatever reason, in many cases they accumulate; these accumulated dividends are paid to preferred shareholders before common holders collect a dividend. Another benefit has a very timely application: When a company issues additional common equity to either shore up its balance sheet (in the recent cases of a number of financials) or for other purposes, it dilutes the holdings of other common stockholders and can often be joined at the hip with a cut or elimination of the common dividend. This event can have an unsettling impact on the prices of preferreds, but it can also help keep the preferred dividend intact. Moreover, in the event of a liquidation event, preferred shareholders are higher in the pecking order than common holders; they have dibs on a bankrupt firm's assets before other equity investors.

Preferred securities aren't a perfect asset class. Although holders of preferred shares can cut in line in front a bankrupt company's common holders when staking claim to its assets, they must stand behind the firm's creditors. Also, unlike owners of common shares, preferred holders rarely have any corporate voting power--a price they pay for their preference over common equity owners in other areas.

All in all, though, we think the advantages of preferred shares are pretty significant, especially for financial institutions in this stormy weather. Recent results of PowerShares Financial Preferred Portfolio help support our opinion. Yes, the fund's total return was a loss of 9.4% in June. However, that wasn't much worse than the total return of negative 8.4% the more diverse iShares S&P 500 Index generated, and it was certainly better than the negative 19.1% total return of the Financial Select Sector SPDR. Also, keep in mind June was a gut-wrenching month, not just for financials, but for the entire market. On a year-to-date basis through June, PowerShares Financial Preferred Portfolio's total return is negative 1.2%, which looks pretty darn good compared with the same measurements for iShares S&P 500 Index and Financial Select Sector SPDR of negative 11.9% and negative 30.3%, respectively.

James M. Walden, CFA, is a stock analyst with Morningstar.