For Preferred Shares, Active Management Has Paid Dividends

The debate over the benefits of active versus passive management is long-ranging, well-documented, often contentious, and ultimately not an either/or proposition. As a supporter of moderation and compromise, I believe that both actively managed and passive products have a place in an investor's portfolio. Can a domestic-equity fund manager continuously outperform any of the numerous broad-market exchange-traded funds? The odds are against it. But can an active fund manager beat an ETF that invests in a less liquid, multifaceted investment space? Perhaps. For instance, a number of contributing factors in the preferred-share universe have provided active managers with an opportunity to outshine their ETF counterparts.

First, let's start with a quick review of preferred shares. Preferred shares are hybrid securities with characteristics of both equities and bonds. Financial institutions, utility companies, and telecommunication firms issue the bulk of these securities. Regular income payments to preferred shareholders are typically higher than interest earned on a bond issued by the same company because of added risks. Preferred shareholders have no voting rights, are senior in the capital structure to common stock but junior to debtors, and have priority over common stock in the payment of dividends. Although it's an equity security, preferred shares generally don't participate in the earnings growth of the company and the resulting common-stock appreciation. The most important attribute for this discussion is that while maturities are long (often more than 20 years, sometimes perpetual), many preferred shares can be called (usually at par value) at the discretion of the issuer, typically after a lockup period.

Now back to the issues at hand. Over the last few years, financial regulations have cast a cloud of uncertainty around these securities, specifically Trust Preferred Shares (TruPS), a type of preferred share often issued by banks. That uncertainty has been decreasing the supply of TruPS, which make up a large part of the preferred-share universe. (While the regulations have yet to be finalized, industry experts agree that the proposals are likely to be adopted with little or no changes this year. For a detailed discussion of the regulations, refer to this article.) Add yield-hungry investors to a shrinking supply and the result is market prices that have been pushed higher, sometimes above par value. But even at prices above par, yields on preferred shares often remain attractive.

So far, this doesn't sound too terrible, but here's the rub: early redemptions. There are a number of reasons a firm may redeem its preferred shares, but an important one is cost. When the dividend rate paid on the outstanding preferred security is higher than the market rate, a firm likely can find cheaper alternative financing. Because of provisions laid out at issuance, TruPS often can be redeemed before the lockup period ends if there is a "capital treatment event." Many issuing firms believed such an event occurred in light of the proposed regulations and redeemed outstanding TruPS at par (for a detailed look at early redemptions, refer to this article). To recap, a shrinking supply and an increased demand pushed market prices higher than par value, but there was a sudden increase in early redemptions at par. This spells trouble.

Active Management to the Rescue
While there are a relatively small number of actively managed preferred-share funds, it's easy to spot a big difference in returns compared with indexes and ETFs. Closed-end funds, or CEFs, account for a majority of the active offerings, likely because their closed structure helps shield investors--the inflows or outflows associated with open-end funds can present an additional risk to managers focusing on the relatively small and less-liquid preferred-share universe. Perhaps mutual fund managers are becoming less concerned with this potential risk as three preferred-share mutual funds launched in 2010 and 2011.

There's some evidence suggesting actively managed preferred-share funds have had an edge over their passively managed rivals. The table below shows performance and yield data for preferred-share ETFs, mutual funds, CEFs, and two preferred-share indexes.

As the table shows, every single CEF and mutual fund outperformed every single ETF and both indexes over the last year and over the last three years. What's more, of the funds with a five-year history, most CEFs (nine of the 12) and the single mutual fund beat both ETFs over five years. Though only some of the CEFs have a 10-year history, all outperformed the Bank of America Merrill Lynch Preferred Index over the 10-year annualized period.

 

How can this be? While the answer isn't definitive, a strong hypothesis is that actively managed funds can avoid owning premium-priced preferred shares with high call risk. ETFs and indexes simply hold a representative basket of securities, regardless of price or call risk. A number of CEF managers I speak regularly with have been exceedingly concerned with call risk over the last few years, and many placed additional emphasis on this issue during analysis.

Leveraging Your Assets
If active management helped these funds, why did the CEFs benefit so much more than mutual funds? The answer here is leverage. Investors less familiar with CEFs should not be scared off by the mention of leverage. Over time, when used prudently, leverage can boost long-term total returns. Think about it. Why do we invest? I hope the answer is because we believe that, over time, our money will be worth more than it is today. If we believe that the market goes up over time, why not leverage our exposure to it? For CEFs, the table below shows current leverage ratios and the type of leverage used. The leveraged CEFs currently borrow at floating rates, generally short-term Libor plus a spread. For all funds existing prior to 2008, it also compares net asset value returns during 2008 and 2009.

In the case of preferred shares, leverage is even more enticing. Preferred shares are usually very long term in nature and leverage is typically created with short-term borrowings or the issuance of preferred shares paying dividends based on short-term rates. When the yield curve is upward sloping (meaning long-term rates are higher than short-term rates), funds are borrowing at lower short-term rates and investing the proceeds at higher long-term rates. Over the long term, the compounding effect of leverage can be huge.

Of course, leverage can at times amplify a fund's losses in the short term--take 2008 for example. The average preferred-share CEF lost nearly 40% while the only ETF and mutual fund in existence-- iShares S&P U.S. Preferred Stock Index (PFF) and Nuveen Preferred Securities (NPSAX)--lost less than 25% each. But, the CEFs were not forced to sell off holdings at fire-sale prices to meet investor outflows (an advantage of their closed structure) and thus bounced back more heartily in 2009, and they've led the pack over the five-year annualized period. Leverage adds volatility, but investors willing to stick with a fund for the long term may be handsomely rewarded.

To be sure, not all of the CEFs are winners here (take the John Hancock suite of funds, for example, which trailed its CEF and open-end peers last year). The four mutual funds performed well over the last year despite the inherent advantage a leveraged CEF may have. But over the three- and five-year time periods, those same John Hancock CEFs outpaced Nuveen's mutual fund offering and some of its CEF peers (see Table 1). As with any investment, short-term results should be taken with a grain of salt.

Of the many preferred-share CEFs, we have a few favorites. While we only provide a Morningstar Analyst Rating on one of Flaherty & Crumrine's CEFs-- Flaherty & Crumrine Preferred Securities (FFC)--we believe the firm to be one of the best in the preferred-share business. Most managers and analysts have decades of experience investing in preferred shares and an emphasis on valuation and trading has helped the fund's long-term results by avoiding overpriced securities. We also like John Hancock's suite of preferred-share funds. A focus on utilities and energy firms has helped returns in the past, but the funds also hold a fair share of financials. Though returns last year were subpar, long-term results are strong and the volatility of returns has been a bit lower than most of the CEFs in the peer group.

To be sure, three of the John Hancock funds and all four of Flaherty & Crumrine's funds are selling at premiums. We encourage CEF investors to use relative premiums, not absolute premiums and discounts, to make valuation decisions. We also recommend that investors keep an active watch list and monitor share price movements, purchasing CEF shares when prices are temporarily depressed.

Overall, investors should be open to including both actively managed and passive investments in their portfolios. In the case of preferred shares (a satellite holding at best), there are some enticing actively managed options.