FPE ETF Beats Its Peers In A Lagging Asset Class

FPE strategy and portfolio

The First Trust Preferred Securities and Income ETF (NYSEARCA:FPE) is a high yield fund paying monthly distributions with a distribution rate of 6.01% and a total expense ratio of 0.85%. It was launched on 2/11/2013 with the objective “to seek total return and to provide current income”.

The fund doesn’t track an index. As described by First Trust in the prospectus, it is actively managed based on “three significant areas of analysis: credit fundamentals; relative value; and technical aspects of the securities, which may include, but are not limited to, interest rate sensitivity, call features, covenants, maturities, trading volumes, liquidity and pricing inefficiencies.”

About 54% of asset value is in securities issued by U.S. companies. The next chart plots weights of the fund’s top countries excluding the U.S.

The next table lists the 12 holdings that are above 1% of asset value (source: First Trust). Their aggregate weight is about 16%.

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Performance

Since March 2013, FPE has beaten its 3 major competitors in the same asset class: the iShares Preferred and Income Securities ETF (PFF), the Invesco Preferred Portfolio ETF (PGX) and the SPDR ICE Preferred Securities ETF (PSK). It also beats a diversified corporate bond fund: the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD). However, it is far behind the equity benchmark S&P 500 (SPY).

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Year-to-date, FPE beats not only its competitors, but also both the equity benchmark and the corporate bond ETF (see next chart).

The table above shows a concerning fact: the annualized return reinvesting all distributions, without paying any tax on them, is inferior to the distribution rate. This points to capital decay. It is confirmed by FPE share price history (without dividend): it has lost about 18% since inception.

Distribution history shows another concerning fact: the annual sum of monthly distributions went down from $1.13 in 2014 to $0.91 in 2021 (source). The distribution for the first 9 months of 2022 is $0.77, so the annual sum may be about $0.92 this year if it stays on the same path. Based on 2021 numbers, the loss in annual income in 7 years is 19.5%. These numbers are not as bad as for SPFF in the same period (review here), but they are not attractive.

In summary, FPE has done very well relative to its peers in the same asset class. The issue is that, in general, this asset class has suffered capital decay and income stream decay for years. I doubt it will do better in the future. The full picture for an income-seeking investor must also take into account the additional drags of inflation rate and tax paid on distributions. This issue is not specific to preferred stock ETFs: securities with yields above 6% suffer from capital decay, on average (there are rare exceptions). The 10-year average annualized return including dividends of all ETFs with a yield of 6% or more is well below the average yield.

How to manage capital decay in high yield securities

Capital and income decay is a structural issue in many closed-end funds, like in most high-yield instruments. However, it is not inexorable if one knows how to trade CEFs instead of using them as buy-and-hold instruments. I designed a 5-factor ranking system statistically related to forward returns across the full CEF universe, and started publishing the 8 best ranked liquid CEFs in Quantitative Risk & Value (QRV) after the March 2020 market meltdown. The list is updated every week. Its average dividend yield varies around 7-8%. It is not a model portfolio: trading the list every week is too costly in spreads and slippage. Its purpose is helping income investors find funds with a good entry point. In the table and chart below, I give the hypothetical example of starting a portfolio on 3/25/2020 with my initial “Best 8 Ranked CEFs” list and updating it every 3 months since then, ignoring intermediate updates to limit transaction costs. Returns are calculated with holdings initially in equal weights without rebalancing until the next 3-month update. Dividends are reinvested at the beginning of every 3-month period.

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The usual disclaimer says that past performance (real or simulated) is not representative of future return. To be honest, the “Best 8” list is unlikely to perform as well in a near future as since March 2020. The 2020 meltdown and recovery resulted in price dislocation and exceptional opportunities in the CEF universe. The 2022 downturn was also a source of opportunities in energy and infrastructure funds. This is unlikely to be reproducible in the future. However, I think a discount-driven rotational strategy in CEFs has a much better chance to protect both capital and income stream against erosion and inflation than any high-yield passive investment like FPE. Dates and lists can be checked in QRV post history.