Investing in an ETF of preferred stocks could pay off, but it could also lead you to take on more risk than you expected

We still feel that investors will profit the most with a well-balanced portfolio of high-quality individual stocks, but ETFs can also play a role in a portfolio.

ETFs trade on Canadian and U.S. stock exchanges, just like stocks. They allow an investor to invest in a group of stocks or other investments. Some investors choose to invest in an ETF of “preferred stocks”—a class of shares that are entitled to a fixed dividend payment.

In addition to offering a fixed dividend payment, in the event of company bankruptcy, an ETF of preferred stocks gives shareholders of those preferreds a higher priority claim on company assets than common shareholders. Dividends on preferred shares must be paid out before dividends to common shareholders.

Investing in an ETF of preferred shares sounds like a lucrative investment, but like most investments, there are hidden risks. We feel you should downplay or avoid ETFs of preferred stocks. Preferred shares offer higher current income than bonds or stocks, but they provide at best a false sense of security.

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The hidden risks of investing in preferred shares and the ETFs that hold them

Before you can invest in an ETF of preferred stocks, you should first know that preferred dividends are not guaranteed. Companies only pay their preferred shares if they choose to do so.

The dividends are “preferred” in that they get paid before dividends on common shares. Sometimes, however, companies fail to pay dividends on preferred or common shares.

When sold individually outside of an ETF, companies often include special features known as “extras” or “sweeteners” in the deal to make an offering of preferred shares palatable to investors. Experienced, successful investors are more likely to refer to the special features as “bells and whistles.” That’s because they exist to distract you so you overlook the negatives.

One key negative of some preferred-share ETFs is that they may claim to generate annual returns much higher than the current dividend yields of individual lower-risk preferred shares issued by, say, banks or utilities. To get yields that high in preferred shares, the managers of the ETF would have to focus on one or both of a couple of high-risk tactics.

They could shoot for an 8% to 9% return by targeting the riskiest preferreds. However, high yields are a sign of danger, rather than a bargain, especially in preferreds. After all, the best you can expect from preferred shares is to receive the dividends they kind of promise (remember, there’s no guarantee). Surprises will tend to be unpleasant.

If the preferreds pay less than expected, or cut out dividends entirely, the price of the investment will plunge and turn that hoped-for 8% to 9% gain into a loss.

Why success of an ETF of preferred shares is tied to interest rates

You may not be aware that preferred shares are a form of fixed-return investment. That means that prices of preferred shares are inversely correlated to interest rates. Simply put, this means that when interest rates go up, prices of fixed-return investments tend to drop.

This is particularly important today. Interest rates have been moving sideways-to-downwards for the past four decades, from the mid-teens percentage rates of 1980 to the recent close-to-zero rates. With rates as low as they are—as low as they’ve ever been—they can’t go much lower.

However, interest rates could double from current levels and only get back into the historical average. This suggests to us that the next big move in interest rates, whenever it comes, is likely to be upward. That means now is a poor time to buy fixed-return investments of any sort.

That means it’s also a bad time for buying an ETF of preferred stocks. After all, preferreds are the low-quality cousins of the highest-quality fixed-return investments, government bonds. A rise in interest rates would push down the prices of fixed-return investments of any sort. It could also hurt the business prospects and cash flows of risky companies whose preferred shares already offer a high yield, due to their above-average risk.

If you want income, you’re better off owning a diversified portfolio of high-quality, dividend-paying stocks. Use our three-part Successful Investor approach to find those stocks:

1. Invest mainly in well-established, dividend-paying companies;
2. Spread your money out across most if not all of the five main economic sectors (Manufacturing & Industry; Resources & Commodities; the Consumer sector; Finance; Utilities);
3. Downplay or avoid stocks in the broker/media limelight. 

Some negative qualities of preferred stock ETFs include interest rate risks, no voting rights, and minimal growth. What’s driving your interest in these investments?