Preferred stock ETFs make up a healthy chunk of our fixed income portfolio. We like them for their high income characteristics and lower volatility compared to the S&P 500. They are especially attractive in IRA accounts, where 100% of the yield is earned, tax free. Given that equity market returns are expected to be lower in the years ahead, the case for preferred stock ETFs is very compelling.
The case for preferred stock ETFs
As the stock market has provided solid and steady returns for much of the last year (and decade), concern is building that future returns will be lower. Vanguard, for example, projects that the US stock market will return between 2.5-4.5% annualized over the next 10 years:
If Vanguard’s projections are accurate then those returns would be below the current yield of the two preferred stock ETFs we invest most heavily in: PFXF & PFFD, which currently yield 4.86% and 4.81%, respectively. That means that a $10,000 investment in either ETF will receive ~$480 in dividend payments over the course of the next year. What’s nice about these ETFs, is that unlike traditional dividend paying stocks, they make distributions monthly, not quarterly.
What about owning dividend ETFs?
Investors often take unnecessary risk when choosing to invest in high dividend ETFs in hopes of capturing a high yield. Data suggests that high dividend ETFs tend to underperform the S&P 500 as a whole while proving to be more volatile than the index itself. That’s a poor combination. If you’re going to take on added volatility, you should be compensated with a higher rate of return.
Take SPYD, which is SPY’s high dividend companion, in the last three years it has lagged the return of the SPY by 40%! Furthermore, it has trailed the return of our preferred stock ETFs as well:
What have you gotten in exchange for that (relatively speaking) terrible performance? Significantly higher volatility! When comparing SPYD to SPY or our two preferred stock ETFs, SPYD has experienced the highest volatility of the group by far over the last five years (note: SPYD began trading in 2015):
Remember, a high dividend payout does nothing for you if the payout is offset by share price volatility.
Using IRAs to earn tax-free income
IRA accounts offer a major advantage for income investors in that all of the income is earned tax-free. Let’s look at an example for a married couple earning $200,000 per year. PFXF pays 4.85%… for our married couple to get that same yield, after-tax, they would need to earn 6.66% (nearly 40% more). So if you’re a high earner, you may consider preferred stock ETFs to be especially valuable inside of IRA accounts.
In summary, when constructing your portfolio make sure you consider the benefits of preferred stock ETFs. A few of our favorites are PFFD, PFXF, PFF, and VRP. If future returns for stocks are lower, then preferred stock ETFs could outperform the S&P 500, especially on a risk-adjusted basis. Be cautious about high-dividend ETFs as a source of income, they don’t have a great track record. Lastly, make efficient use of preferred stock ETFs by including them inside of IRA accounts, where 100% of the yield will be earned.
Don’t want to miss anything?
Subscribe to our monthly newsletter for market insights.