Tuesday, 30 November 2010

New iShares Preferred Share ETF - How Does It Compare?

The November 16th launch of trading in the brand new iShares S&P/TSX North American Preferred Stock Index Fund (CAD-Hedged) ETF (symbol XPF) brings competition to the income-oriented preferred share space. Up to now, Claymore's S&P/TSX CDN Preferred Share ETF (CPD) has been the sole such ETF traded in Canada, though various other ways exist to acquire preferred shares for a portfolio, as we described in a previous post Preferred Shares: an Opportunity for Taxable Accounts. Let's see how the new XPF compares to CPD and to a major closed-end fund for preferred shares, the Diversified Preferred Share Trust (DPS.UN) managed by Sentry Select Capital Inc. We note in passing that Horizons AlphaPro has also just launched a preferred share ETF (symbol: HPR) but the skimpiness of information on the ETF's webpage prevents us from assessing it here.

Key Comparison Factors:
(for details click on the table image below)

Costs: Management Expense Ratio, Trading Costs, Hedging - CPD has the edge due to: a) its low MER; b) its higher trading volume, which keeps bid-ask spreads low and; c) the absence of hedging cost. The decision of iShares to do currency hedging for the US portion (which is about half the total portfolio) of XPF's holdings, in order to remove the often dramatic swings in the US and Canadian dollar exchange rate, costs money and reduces returns, as we discussed previously in Foreign Currency: To Hedge or Not to Hedge Currency. How much return reduction there will be for XPF from hedging only time will tell but it is not negligible.

Riskiness - There are several dimensions to the relative riskiness of these funds.

Credit Risk
(the risk of the promised dividends not being paid) -
XPF has the highest number of issuers with about three times as many different companies represented in its directly held Canadian shares and in the underlying holdings of the US iShares ETF (symbol: PFF), through which it indirectly holds US preferred shares. This lessens the impact of a suspension of dividends by any single company. However, XPF has an appreciably higher concentration of its total holdings in financial services. Included are a number of US banks, an exposure that CPD does not have at all. No less than 86% of the holdings of PFF and 85% of XPF in total are in the financial sector. DPS.UN unfortunately does not reveal the sector breakdown or the Canada-US allocation so we are unable to compare this aspect of the credit risk for this fund.

The Credit ratings agencies provide ratings on the credit risk of individual preferred shares and these ratings further confirm the above indication of XPF as a more aggressive and riskier investment than its rivals. The combined ratings on both US and Canadian holdings (unfortunately and disappointingly for the investor, iShares does not give the breakdown for the Canadian holdings and we have estimated using the excellent detailed tables of Scotia McLeod's Guide to Preferred Shares Winter 2010) reveals that XPF has 26% of its holdings in securities rated lower than safe investment grade and a substantial dollop in speculative issues on the US side. By contrast, CPD has only 20% of holdings below investment grade and none of the speculative grades, making it a much safer portfolio overall, while DPS.UN only discloses the overall credit risk of its fund, which is the lower rung of investment grade, PF-2 on our table.

Interest Rate Risk
- A rise in interest rates will put downward pressure on the prices of preferred shares just as it does to bonds. The best way to assess this factor is by the type of preferred share since some types can adjust to interest rates, such as floating rate shares, and are much less susceptible to capital declines from interest rate increases. Again, Scotia McLeod's guide comes to our help with explanation and a handy chart, reproduced below, that gives a general idea of the various types of preferreds and how they compare for interest rate risk along the horizontal axis.

CPD has appreciably less interest rate risk than DPS.UN due to its much lower proportion invested in the most interest-sensitive straight perpetuals and higher amounts in the floaters. With XPF the investor is in the dark as this critical information is absent from the documentation on the iShares website.

Leverage - DPS.UN contains an additional risk factor, namely that the fund has borrowed money, which has then been invested. This is done in order to benefit from the fact that the money borrowed at prime rate, which in 2009 averaged around 3% according to DPS.UN's financial statements, can generate returns at higher dividend yields. That boosts investor returns and is evident in the higher distribution yield of DPS.UN, but it increases risk since the borrowed funds must be paid back.

In the event of a jump in interest rates, the borrow-vs-invest yield advantage would diminish or disappear at the same time that the capital value of the preferred share holdings would fall. The DPS.UN managers would then want or need to to cut down the debt but repayment would come from selling those preferred share holdings whose value had fallen. The fund and its investors could take a big hit on capital value. The question is whether the DPS.UN managers will be nimble and perceptive enough to anticipate interest changes and reduce leverage at the right time. The beneficial effect - so far - is seen in the year-to-date results as DPS.UN has gained 11.2% YTD, much more than its simple dividend yield, while CPD is much closer to its dividend yield with a 6.7% YTD gain.

Return, Yield and After-Tax Cash Flow - Both XPF and DPS.UN offer a little more than 1% higher pre-tax distribution yield than CPD.

More than 50% of the annual distributions from XPF will be taxed in a Canadian investor's hands as other income at the higher marginal rate instead of the lower eligible dividend rate. That does not matter if XPF is held in a registered account but it significantly reduces the after-tax net yield in a taxable account (e.g. if you are in the highest marginal tax bracket of 46.41% for 2010 in Ontario, that's how much you will have taken off - see this TaxTips.ca page for all the personal tax rates across Canada). Much better are both CPD and DPS.UN, which give off the tax-preferred eligible dividends (the highest Ontario marginal rate on eligible dividends is only 26.57%) as well as Return of Capital, which is not taxed immediately at all and only later as a deferred capital gain when he/she eventually sells the ETF holding (see our previous post on Calculating Capital Gains in ETFs and Mutual Funds).

Features: Distribution Frequency, Automatic & Commission-Free Purchases and Withdrawals -
For investors wanting to receive and spend / withdraw the income, e.g. while in retirement, the monthly distributions of CPD and XPF can help with budgeting and cash flow.

Another feature, free and automatic pre-authorized systematic withdrawals by selling shares, can boost the cash given off by distributions. Alternatively, in the portfolio build-up years a DRIP that reinvests the income into the purchase of extra ETF shares automatically and without trading commissions is a big convenience and cost saver. CPD offers both systematic withdrawals and DRIP as an optional choice while XPF and DPS.UN do not.

Which is best overall?
For the investor who seeks steady, reliable income with as little risk as possible, Claymore's incumbent CPD is the clear winner. Sentry's DPS.UN and the new iShares XPF are less attractive choices due to their several weak spots or unknowns compared to pluses - the extra return just doesn't seem worthwhile enough.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

1 comment:

Anonymous said...

Thanks mid 50's guy. You have done great homework here .. also liked your assessment of HXT vs XIU ... keep up the fine work !