If You “Prefer” Financials

09/29/2008 12:00 am EST

Focus: ETFS

Scott Burns

Director of ETF Analysis, Morningstar, Inc.

Scott Burns, editor of Morningstar ETFInvestor, finds a niche ETF that specializes in preferred shares issued by financial institutions.

The PowerShares Financial Preferred ETF (Amex: PGF) is a market-capitalization-weighted index created to track the results of certain preferred securities issued in the United States by financial institutions. (Neither Fannie Mac nor Freddie Mae is represented in this portfolio, but Lehman Brothers is.)

It’s good for people who are looking to make a more conservative investment in the financial sector than owning a simple equity sector ETF such as Financial Select SPDR. Preferred shares are a hybrid of debt and equity instruments, offering a consistent debt-like payout without the benefit of the elevated claims of debt in a restructuring. Although the risk on preferred shares is greater than debt, the investor is compen­sated with higher yield.

Adding preferred equity securities to a port­folio is analogous to adding fixed income. The caveat is that, given the hybrid nature of preferred shares, these securities [are] much more volatile than fixed income. The Financial Preferred fund has a nearly 50% exposure to interna­tional financial institutions.

Like all preferred stock securities, PGF benefits from the fact that its divi­dends are taxed like common dividends. At current rates, this means a 15% tax rate, compared with fixed-income or bond interest payments that are taxed as ordinary income at the investor’s maximum tax rate.

The financials sector has certainly been taking its lumps lately, and we expect weakness to continue. As a result of this turmoil, we have seen a steady increase in the uncertainty ratings that analysts have been assigning to companies in this index. This high­lights the pressure that banks and other financial institutions are likely to continue facing throughout the remainder of the year.

Even with these short-term disruptions in the finan­cials sector, the components of this index are trading at a pretty deep discount to their long-term intrinsic value. Although there are some deep values in the sector, the risk to equity holders—both common and preferred—has certainly increased as trouble in the credit markets continues to unravel.

Before July, Financial Preferred ETF had held up considerably better than its financial common equity cousins, but fears [about] bank failures and a continued collapse of the mortgage market even put the security of structurally superior preferred shares in doubt. Although things have settled down quite a bit, this should serve as a reminder to any would-be investor that there is still a decent amount of risk inherent in this ETF.

Even after adjusting for the risk, we currently think it is undervalued. (PGF closed below $16 Friday—Editor.)

With an expense ratio of 0.72%, this is not the cheapest ETF. As one of the few preferred ETF offer­ings around, it doesn’t really have a lot of competition right now. The broader fixed-income-oriented iShares Lehman Aggregate Bond (Amex: AGG) sports a 0.20% fee.

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