It’s hard to keep a straight face while arguing for active strategies in asset classes like large-cap stocks or government bonds. Those markets are so liquid and so well covered by analysts that it’s almost impossible to find and exploit inefficiencies. But many would argue that active managers at least have a fighting chance in less efficient asset classes like, say, emerging markets or small-cap stocks.
On the heels of my previous posts on Canadian preferred shares, let’s consider whether this is another asset class where active managers can be expected to add value compared with a simple indexed approach using ETFs. I recently explored this idea in a conversation with Nicolas Normandeau of Fiera Capital, who manages the Horizons Active Preferred Share ETF (HPR). I think it’s worth having these debates occasionally, because if you believe in indexing, you should be able to defend the strategy with rational arguments and not ideology.
Here are the main arguments in favour of using an active strategy with preferred shares:
The market is complex and inefficient. The entire preferred share market in Canada is about $60 to $65 billion—about the same as the market cap of Canadian National Railway. Yet within this relatively small market is a dizzying array of issues, each with its own unique set of options, provisions and features.
If you want to buy a bond issued by Fortis, Normandeau explains, you can simply look at the company’s credit rating and then pick the maturity you want. But preferreds are much more complicated: Fortis alone, for example, has seven different issues with various features.
In a market with this level of complexity, it should be easier to find mispriced securities and take advantage of them. “We can find a lot of arbitrage opportunities,” Normandeau says. “With corporate bonds you might be able to get 20 basis points, but with prefs you may be able to find 200.”
There’s a lot of dumb money at the table. Normandeau says retail investors make up a huge proportion of the market for Canadian preferred shares, and a good number of them are making decisions based on little more than yield. He recalls one recent Royal Bank issue that was almost entirely bought by individuals and advisors. “This was a new structure, so all the institutional guys were reading the indentures and asking about the reset mechanism, the formulas they were using, and so on. But retail investors were just buying Royal Bank and the 4% yield. They didn’t really look into the details of what they were buying.”
Of course, naive investors are part of every market. But if they’re buying a few hundred shares of Royal Bank’s common stock it’s not going to have a meaningful impact, because there are more than 1.4 billion shares outstanding. In the preferred market, however, where volumes are much lower and retail participation higher, professionals may be able to take the other side of those trades and exploit the dumb money.
Index ETFs lead to more inefficiencies. Now to the most controversial claim of active managers: some feel the dumb money in the Canadian preferred share market includes index funds. “Like all passive managers, if the security is big enough and the credit rating is high enough, they add it to the index,” Normandeau says. “They don’t do credit analysis or duration analysis like we are doing in HPR.” When a company has multiple preferred share issues, “the indexers are buying whatever is in the benchmark,” he says, “but we are picking the ones that have the best value from each issuer, and then you can do this from one issuer to another.
Moreover, preferred share index ETFs in Canada now make up a significant share of the overall market. The iShares S&P/TSX Canadian Preferred (CPD) has about $1.4 billion in assets, while the BMO S&P/TSX Laddered Preferred Share (ZPR) is also about $1.1 billion. That makes them as the 10th and 16th largest ETFs in the country, respectively, as of the end of February. “So together they make up more than 3.5% of the market, and they’re trading quite often in large quantities,” Normandeau says.
Large flows in a small market create opportunities for active managers to gain an upper hand, he argues. “We’re seeing it every day: we know when these guys are buying or selling. I am never a forced buyer or a forced seller: I can do whatever I want with my cash. With prefs, if you want to buy or sell with big flows, you’re going to pay a high price. What you should do is try to trade on the other side of that.”
Meet you halfway
So, what to make of these claims? Unless you’re an indexing fundamentalist, you have to acknowledge that preferred shares offer comparatively more opportunities for a skilled manager to identify mispriced securities, at least when compared with most other asset classes.
I’m not the only committed indexer who admits that. Norbert Schlenker (of Norbert’s gambit fame) has used the services of James Hymas, generally recognized as Canada’s guru of preferred shares. “I disdain active investing,” Schlenker wrote at the end of a glowing testimonial in 2011. “I realize that the above smells very much like the usual ad for an actively managed fund. I intend no such thing. I am just a happy client, happy to see that my default investing philosophy is wrong in this instance, and happy to recommend Hymas’s services to others.”
But I reject the idea that index funds are part of the dumb money. From the moment index funds were created in the 1970s, fund managers have talked about taking advantage of mindless passive investors, but the proof is in the performance, and the data show that only a tiny minority outperform over meaningful periods. While our practice in Toronto does not use preferred shares in client portfolios, other advisors at PWL Capital use the BMO S&P/TSX Laddered Preferred Share (ZPR), which we recommended in our recent white paper on the subject.
That said, I wouldn’t argue too strenuously with anyone who chose to use a low-cost, prudently managed active fund to get access to preferred shares. (HPR, for example, had an MER of 0.64% in 2014, only slightly more than its indexed counterparts.) Certainly that’s a wiser decision than trying to manage a portfolio of individual preferreds on your own.
I am glad you are taking a look at this area. At this point, I have sold off most of my stocks as I have shifted to passive ETFs, but I currently have a few stocks left. One of them is an older issue preferred share from Enbridge, (please no hate replies….If you look at your Canadian equity ETF you will find Enbridge in there too.)
At any rate, I have been getting 5.5% dividends from this preferred for many years now, in my kids RESP and I haven’t felt the need to sell it. I took your suggestion to switch some of my other holdings over to GICs as my eldest is getting closer to graduation. It kills me to see the 2.55% I am getting from the GICs while this keeps a steady supply of cash on a quarterly basis and I can sell it when I need to without penalty. The GICs are locked in. I know, the company could go bankrupt and I would be out of luck, while my GICs are safe.
I have no desire to hunt down preferreds at this time and current yields for new issues aren’t yielding at those levels. I do wonder if I may look at them again more closely when it comes to retirement income stream, in a “few” years. I would rather pick and choose myself unless the ETF management fees go down to Vanguard levels.
@Chris: Thanks for the comment. I often hear people say they would rather “pick and choose” preferreds (or bonds) rather than paying a small management fee to an ETF. But that ignores several issues: first, the retail pricing on fixed income is generally terrible. Preferreds, especially, can be very expensive to buy and sell. And, as we argued in the white paper, picking individual issues requires a lot of expertise and will almost certainly leave you with inadequate diversification. With that in mind, a fee of 0.50% or so is good value.
I believe the symbol for the Horizons Active Preferred Share ETF is HPR not HPD.
I enjoyed this article. Thanks
@John: Thanks, typo fixed.
I won’t comment on whether preferred share indexers are dumb money but retirees who have ALL their eggs in the preferred share ETF basket could be classified as “dumb income” investors. Preferred share ETFs have seen a steady decline in distributions for the past several years. Case in point…Horizons Active Preferred Share ETF (HPR) annual distributions since inception:
2011 – $0.4973
2012 – $0.4417 (11.18% decline)
2013 – $0.4338 (1.79% decline)
2014 – $0.4113 (5.19% decline)
2015 YTD (10.34% decline)
@Bernie you’re going to see declining distributions in almost any fixed income fund though, due to a long term trend of declining interest rates. That doesn’t necessarily mean the fund is doing a poor job.
I do agree with you that concentrating a large portion of one’s portfolio in preferred shares (be it individual issues or a fund) is a bad idea.
Each to their own I guess but I invest for income growth. It would scare the dickens out of me if my income stream from investments started declining. Heck, I’d be upset if my income growth failed to exceed the inflation rate.
I’m still holding CPD and did a comparison with the returns of the Horizon Managed HPR, there is not a huge difference, sometimes one will get the upper returns, sometimes the other. Here is the 5-year graph I found:
I was thinking that if Horizon was making superior returns, I could sell the CPD (loss) and buy into the Horizon for hopefully greater gain. But the advantage of “Active” doesn’t seem to be there.
@Bernie but you know when you buy the fund that the distributions are going to decline over time, because it’s full of premium shares. Also, for every large distribution you get, the NAV falls, so if you want to maintain the high cash flow, you can just sell shares for exactly the same result. What really matters isn’t the distribution yield, but rather the yield to maturity (in the case of a bond fund), or yield to worst (in the case of a preferred fund*).
*Yield to Worst (or YTW) is a bit trickier to calculate since there are different types of preferred shares with different options, so when comparing between funds, you need to look at the assumptions they’re making. Here’s a bit more discussion on that from James Hymas (in his classic… straightforward style): http://prefblog.com/?p=748
Thanks for this series of articles on preferred shares and also for the in-depth white paper. I read Garth Turner’s blog and he’s always mentioning them as another asset class to hold and it made me wonder if the Couch Potato Portfolio is “too” simple :) Glad to see the real numbers from the white paper and also to read about the possible risks. It doesn’t seem like there’s enough benefit for me to worry about them (and it’s one less thing to balance).
Another informative artice. Thanks.
While the argument that: “preferred shares offer comparatively more opportunities for a skilled manager to identify mispriced securities,” sounds reasonable, do the numbers show that this is actually the case?
Is there any performance data available that compares actual performance of index Preferreds share ETFs or mutual funds versus actively managed preferred share ETFs or mutual funds? I note that Alan did one such comparison in the comments above.
It’s easy to make a persuasive academic argument, it can be more difficult to show actual results that support the argument. As you say “the proof is in the performance.”
@Alan and Tennis Lover: The first point is that comparing ETF performance using tools like Yahoo or Google Finance is highly misleading. In almost all cases, these charts show price changes only, not reinvested dividends, so the information is worse than useless. Fund performance is properly reported as total return, which assumes all distributions are reinvested.
As for the performance of preferred share funds compared with index benchmarks over the long term, I don’t think the data are very rich. There really aren’t a lot of funds that manage only Canadian preferred shares: many of them have broader mandates that make benchmarking difficult. Of course, cost is always going to be the big hurdle. Even an active manager with proved skill will have to charge low fees and keep transaction costs and taxes to a minimum to achieve any meaningful outperformance over an index ETF with a low fee.
Thanks for your input. I didn’t profess to have a great knowledge of preferred share ETFs but I can see they don’t fit for me. My ‘preferred” way of investing has been to stick with vehicles, predominantly stocks, that increase their distributions, or occasionally keep them level. I wish to live solely off the distributions so I never HAVE to liquidate any principle. This has worked well for me so I’ll continue this approach. It’s more hands on but I enjoy managing my own course.
Given the significant loss this year in ZPR, would it make sense to harvest the tax loss and repurchase when more issuers follow Brookfield and CUL and place a floor under their resets?
Thanks for the article and the link to the white paper. I have a few questions concerning this type of yield generating investment which don’t seem to come up …
If I am employing a “buy and hold” strategy (5, 10, 15+ years) then it seems my primary risk is the chance of company failure and loss of the entire principle. If I am only buying investment grade companies (P2 or better, big banks etc.) then it seems I can comfortably generate the tax preferred income I want with very little risk of company failure.
The fact that these shares are thinly traded shouldn’t matter too much to me because after I get in at a price/yield to worst ratio I can live with, and the fact that I am not forced to sell into a bad market (price) should mitigate most of the risk of potential capital losses. Also, if I target shares that are selling for less than par am I not mitigating the possible loss on issuer redemption?
I am new to this so any comment or insight would be greatly appreciated.
Do note that zpr contain rate reset prefereds… While other ETFs may hold straight prefereds… Just because it says preferred, don’t think they are equal