PFFA: Look For A Total Return Of Under 6% (NYSEARCA:PFFA)

Virtus InfraCap U.S. Preferred Stock ETF (PFFA) is a fund that we have covered a couple of times. At the surface, it appears like any other preferred sector fund, but has one big distinction. It sports the largest yield in its space. When we last wrote about this one, we took the high road.

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

The manager has certainly taken up the challenge to maintain the distribution, and we saw an interesting distribution raise. We look at what this fund is paying today and whether it is time to change the tune of the distribution cut we talked about.

The Fund

PFFA is a mid-sized, preferred-focused fund, and current net assets stand at around $544 million. According to their website, the fund aims to underweight or eliminate callable preferred securities exhibiting a low or negative yield-to-call ratio. It also uses modest levels of leverage, a feature that is more prevalent in the closed-end fund world, and not so much in the ETF world. Finally, it also mentions that it might employ option overlay strategies primarily to seek to provide additional current income or even use opportunistic short positions to hedge interest rate risk. Option income is rather unusual blend alongside preferred shares as no preferred shares actually have traded options. This likely refers to using options on common shares as a stand-alone or on common shares where the preferred shares are convertible into common shares at some point. Short positions to hedge interest rate risk are more common relatively speaking. Most of the time this comes via swaps or hedges to lock in shorter-term interest rates, but direct short positions on Treasury ETFs are not uncommon.

Holdings

PFFA runs a relatively concentrated fund with the top 10 holdings approaching 40% of the total.

This is not necessarily a bad thing as it would be hard to generate any alpha if you are owning the entire universe of preferred stocks. The fund does own over 150 total holdings and there we see a general bias towards the lower-rated and higher-yielding preferred shares. This is not entirely unexpected as the sector benchmark ETF iShares Preferred & Income Securities (PFF) has a 30-day SEC yield that is about half as much as what PFFA doles out.

The 30% leverage can add some heft for PFFA, but that also runs into higher expenses from higher management fees and interest costs. If you took the PFF 4.4% and “enhanced” it with just plain leverage, you probably could get to 5.2% after interest expenses. The remaining jump requires you to go down the credit ladder.

Performance

In all cases, we like to review what has happened since the last time (September 2021) we covered a stock or fund. The first thing that stands out is that PFFA increased the distribution. We think some news outlets failed to cover this as this was going past two decimal points.

Nonetheless, if ever there was a challenge to our thesis, this definitely qualified. Readers who followed our older work might have seen the relentless debate on whether InfraCap MLP ETF (AMZA), managed by the same team, was covering the distribution it paid. Our stance was that the distribution did not have a prayer and ultimately it was cut three times. Of course, in all what transpired then, not once did AMZA actually increase the distribution.

While that does create a cautionary note for our prediction, let us look at what has happened to the total returns for this one.

PFFA is down 5% on price, and total returns are negative 2.52%. This part fits with our theory back then that PFFA will struggle to generate total returns of even 6% a year.

If you pay out 8.2% (current yield) a year and the price drops 2% a year, your total return will be about 6% a year. So far, we call this a draw, where our total return outlook has been winning convincingly, but PFFA’s hike has certainly thrown down the gauntlet.

Outlook & Verdict

As much as we would like to claim victory on the total return outlook, we expected it to be far, far worse. PFFA has done exceedingly better than what we would predict. Below we have the total returns versus PFF, the benchmark ETF, and the fact that PFFA has beaten a non-leveraged ETF so convincingly in a selloff, is remarkable. PFFA has also put the hammer down on Global X SuperIncome Preferred ETF (SPFF). We chose this one as it follows the strategy of simply buying the 50 highest yielding preferred shares with no regards to other fundamentals and does not use leverage.

That was impressive.

So Hatfield et al have certainly done some impressive trading in the background and performed extremely well during a difficult period for preferred share investors.

The problem still remains for us on the asset class. This is the call on the forest and not the trees. We expect the asset class of preferred shares to struggle to deliver 5% total annual returns over the next two years. Current pricing structure while better than 6 months back, leaves a lot of room for downside. This will be via fixed rates moving to floating and spreads widening versus investment-grade securities as well.

This is very similar to the idea that Nationwide Risk-Managed Income ETF (NUSI) is one to avoid for us. NUSI uses a collar strategy on the NASDAQ 100 index and our core outlook for that index is exceptionally poor. So regardless of the view on the fund manager’s ability or the strategy, we don’t want to own it. We still think PFFA will struggle to deliver 6.0% total annual returns from our call. We applaud the recent returns generated even though they are negative. Our rating remains neutral on the fund, and we still think the distribution will be cut down the line.

Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.