Daily Gains Letter

Forget the Conventional Buy Stocks and Bonds Strategy, Look at This ETF

By for Daily Gains Letter | Feb 13, 2013

















DL_Feb_13_2013_MoePreferred shares are usually overlooked by Main Street investors. This is mostly because they are, as the name suggests, different types of shares. Preferred shares have different qualities than common shares, and they can provide investors with many added benefits.

Common Shares vs. Preferred Shares

Common shares of a company represent ownership in the company. When an investor buys these types of shares, he or she has the ability to vote in the company’s matters, such as electing the Board of Directors. But, if the company ever dissolves, common shareholders fall in line behind preferred shareholders and creditors.

Preferred shares, on the other hand, represent ownership in the company as well, but they generally don’t have any voting rights.

In addition, preferred shares are a form of equity that provides the same benefit as fixed-income securities. In other words, when you own preferred shares, you own a piece of company; in return, you get a constant stream of income.

For example, if a common share of ABC Inc. trades for $10.00 a share and pays $1.00 per share in dividends, then the yield on ABC Inc. common shares is 10%. Now, if the price goes down to $8.00, the dividend yield now becomes 12.25%. If it goes the other way, the dividend yield decreases.

In contrast to common shares, the dividend yield on preferred shares doesn’t change. For example, if a company issued a preferred share for $25.00 and says that the dividend yield is 10%, then no matter what way the price goes—upward or downward—the investor will continue to receive that 10% yield, $2.50 per share per year.

If a company ever runs out of business, preferred shareholders are the second in line after creditors to get the proceeds from the sale of assets.

How Do You Find Preferred Shares?

Instead of going through a conventional buy stocks and bonds strategy, investors can look to diversify their portfolio with preferred share class.

Take the iShares S&P U.S. Preferred Stock Index (NYSEArca/PFF), for example. This exchange-traded fund (ETF) invests in preferred shares of companies on key stock indices. The iShares S&P U.S. Preferred Stock Index (PFF) is well diversified, holding preferred shares in companies from a range of sectors. As of December 31, 2012, this ETF had a net asset value of $10.8 billion and a total expense ratio of 0.5% (Source: iShares web site, last accessed February 11, 2013.)

In addition, PFF provides investors with a dividend yield of almost six percent per year paid monthly.

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Chart courtesy of www.StockCharts.com

Not only can this ETF provide investors with capital appreciation, but it can also generate income for them. The stock rose as the stock market rose, and it’s still bucking the trend (it has been since early 2010).

Disadvantages to Owning Preferred Shares

While preferred shares have advantages over common shares, they come with some setbacks as well. As they offer a fixed dividend rate, if the interest rates go up, their price also declines—just like bonds. This is because investors can get a better return elsewhere.

In addition, some preferred shares might have a callable clause, meaning that the company which offered these kinds of shares can buy their shares back at any time. This way, investors may miss out on future gains—though they will be paid the amount promised by the company at the time of issuance.

When it comes to investment management, investors shouldn’t just look at stocks and bonds. There are other forms of investments where they can secure their capital while also earning a healthy rate of return—preferred shares are just one of those vehicles.

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