PFFA ETF: Exceptional Trading, Not Enough To Offset Macro Headwinds

When we pass an opinion on an ETF, we pay heavy attention to the macro environment. While we do look at other factors, the macro always trumps everything else for us. This is because even the best managers will struggle to swim against the tide. For example, if you bought an energy fund in 2014, there was zero chance you would have positive returns 1 year later. It did not matter who you chose as your manager. Our 1-year macro outlook called for a massive yield spike and substantial credit stress back in 2021. So it was very easy to make negative calls on popular funds. Whether it was the popular Treasury bond funds like TLT or closed end funds like PIMCO Income Strategy Fund (PFL) and PIMCO Corporate & Income Opportunity Fund (PTY), we were happy to slap on sell ratings. While those calls worked out beautifully, we go over one today where the manager has certainly swam a lot against the tide and made us rethink our decision.

Our Call

When we covered Virtus InfraCap U.S. Preferred Stock ETF (NYSEARCA:PFFA) in September 2021, we gave it a good chance of cutting its distribution.

Based on all the information we have looked at, PFFA has a “High” level of danger of a dividend cut on our proprietary Kenny Loggins Scale.

This rating signifies a 33-50% probability of another dividend cut in the next 12 months.

Source: Schrodinger’s Distributions, 3 High Yielders Likely To Cut

Now on September 12, 2021, if you stepped away from the fund and came back today, you certainly would be treating us to dinner. The fund’s NAV is down 8.72% and even the total return is a negative 3.75%. So you certainly gained by using the caution we suggested.

This part was predictable as investors had never shown such a blatant disregard for restraint in chasing yields as they did back then. We knew the piper would have to be paid when investors were bidding up premiums on PIMCO funds to 5-8 years of after tax distribution yields. For us, PFFA was exposed to the same risks as it was a leveraged fund chasing an interest rate sensitive asset class at potentially the most dangerous time. Nonetheless, we have been quite impressed by what has happened so far. PFFA has handily beaten iShares Preferred and Income Securities (PFF) by about 7% in total returns.

PFFA uses leverage and a lot of it. To show such a huge alpha in a decline is generally unheard of for leveraged funds. PFFA also has taken other leveraged funds to the cleaners in the same timeframe. We have shown Flaherty & Crumrine Dynamic Preferred and Income Fund (DFP) as our leveraged preferred share fund below. Here we compared NAV movements so the changes in discount and premiums of this closed end fund would not cloud the viewers’ eyes. We also threw in PTY, which is a bond fund, but was subject to the same level of stress.

Those results again stand out, especially when many think of PTY as the best ever fund created to manage high yield assets.

What Did PFFA Do Right?

PFFA’s returns can be attributed to two main factors. The first is concentrated bets on its top holdings. This paid off handsomely when its price sensitive preferred share, South Jersey Industries, Inc. UNIT 04/01/24 (SJIV) benefitted from the acquisition of South Jersey Industries, Inc. (SJI).

We should also add that we had suggested that this very issue was quite risky as there was definite conversion coming up and PFFA risked getting hit if SJI toppled. PFFA took that bet (in large amounts we might add) and came out ahead.

The second reason was some exceptional trading done by the managers. We saw this in the huge turnover during this period as the top 10 holdings were regularly replaced by fresh faces. PFFA also emphasized very high coupon rate holdings during this time and these got far less of a duration hit compared to some other names that were held in PFF.

Outlook & Verdict

The primary purpose of the Federal Reserve is to establish credibility and until April 22, 2022, it looked like they were failing. The market is throwing down the gauntlet and telling them they are not buying the hawkish talk. Inflation break-evens actually rose last week, showing that the Federal Reserve has to do a lot more.

Even the perma-bond-bull camp is in panic mode on inflation.

Should the Fed cease in their efforts to calm inflation before it has been fully restrained, bond investors should be wary.

Source: Hoisington

This coming from the group who thought staying fully invested in bonds at 0.5% 10-year Treasury yields was a brilliant idea.

While we think we may be close to peak year-on-year inflation rates, Shanghai’s lockdown has potential to keep inflation uncomfortably high. This backup for example will take months to unwind.

Hence we think there are likely to be even more aggressive surprises from the Federal Reserve and we would be cautious in general on leveraged income ETFs. The trading record to this point though has taken a lot of the pressure off from a potential distribution cut. If the NAV was down 15-20% instead of the 8.72% we have seen, we would press our distribution cut call. But as it stands, PFFA is furiously swimming against the tide. Two thumbs up for the performance.