Many investors faced with a volatile and uncertain equity market in the first half of 2016 are turning their attention to dividend yields. One of the best ways to secure high returns is preferred stock, which commonly offers yields that are twice as much or more than those available on most investment grade bond issues. While even some of the highest-yield investment grade bonds are only paying 2-3% in yield, many preferred stocks offer yields above the 5% level.

Preferred stocks offer investors a hybrid investment that provides attractive, regular dividend payouts while avoiding much of the volatility and risk inherent with common stock. Common stock is subordinate to preferred stock, in that preferred stock carries a higher claim on a company's earnings and assets. Dividends must first be paid to preferred stock shareholders, who have a priority over common stock shareholders. It is also common for preferred stock dividends to be cumulative, which means that if the company misses a dividend payment one year on the preferred stock, it must then make up the deficit in the years following. Preferred stocks usually also come with a built-in tax advantage, in that the dividends paid are qualified dividends that qualify for taxation at a much lower rate than ordinary interest income.

The advantages that preferred stock ETFs offer investors are twofold. First, ETFs offer an easy way to access exposure to a broad selection of preferred stocks, thus diversifying an investor's preferred stock investments. Second, investing in preferred stocks through an ETF can offer investors substantial savings on transaction costs over purchasing individual preferred stocks that may trade with much less liquidity than an ETF. Investors need to be aware that although the dividend yield on individual preferred stock issues is fixed at the time of issuance, the dividend yield on a preferred stock ETF fluctuates somewhat as the portfolio holdings change over time.

The single most widely held preferred stock ETF is the iShares US Preferred Stock ETF (NYSEARCA: PFF), which was created by BlackRock in 2007.

iShares US Preferred Stock ETF

The iShares US Preferred Stock ETF has $14.8 billion in total assets under management (AUM), more than three times as much as the next most widely held fund in the category of preferred stock ETFs. This ETF tracks the S&P U.S. Preferred Stock Index, a market-cap weighted index that includes approximately 300 preferred stocks which are traded on the New York Stock Exchange (NYSE) or NASDAQ exchange. The fund is typically 90% or more invested in the securities contained in the underlying index, but may be up to 10% invested in other securities, swaps, futures or options. Financial services stocks make up 82% of the portfolio. The top five portfolio holdings are Allergan Plc Preferred Stock 03/18 5.5% (NYSE: AGN-PA), HSBC Holdings Pfd (NYSE: HSBC-PA), Barclays Bank PLC (NYSE: BCS-PD), GMAC Capital Trust 1 Pfd (NYSE: ALLY-PA) and Wells Fargo & Company, San Francisco Ca Pfd (NYSE: WFC-PN). In a fund with approximately 300 holdings, there is very little concentration risk. The annual portfolio turnover ratio for the ETF is relatively low at just 13%.

The expense ratio for the iShares US Preferred Stock ETF is 0.47%, notably below the preferred stock category average of 0.55%. As of mid-April 2016, the fund's five-year average annualized return was 6.05%, slightly underperforming the category average of 6.69%. The three-year average annualized return was 5.06%, outperforming the category average of 3.27%. The fund's one-year return of 3.39% also outperforms the category average 1.39%. Through mid-April 2016, the fund was up 1.71% year to date (YTD), still underperforming a category average of 2.8%.

Dividend History and Category Comparison

The iShares US Preferred Stock ETF pays dividends monthly and as of April 2016 has a 12-month dividend yield of 5.79%. The dividend yield for the fund has been fairly steady over the past five years, mainly ranging between approximately 5.5 to 6.1%. However, the annual dividend payout amount and dividend growth have varied significantly year to year. The annual dividend payout amounts for the time period 2010-2015 have ranged from a low of $1.86 in 2015 to a high of $3.10 in 2014. This saw the annual dividend growth rate swing from plus 49.4% for 2014 to negative 39.9% for 2015.

In terms of current dividend yield, this ETF falls somewhere in the middle of the nine ETFs in the preferred stock ETF category. The ETF currently offering the highest yield is the Global X SuperIncome Preferred ETF (NYSEARCA: SPFF), with a 12-month dividend yield of 7.36%. However, with only $200 million in total assets the Global X fund is considerably less liquid than the iShares fund. It also carries a significantly higher expense ratio of 0.58%.

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