With stocks suffering the challenges of Dante's Inferno these days, and investors fleeing all kinds of risky investments, maybe it's time to consider other alternatives for clients' portfolios. Preferred ETFs and preferred mutual funds, unheard of a few years ago, may well be worth a look.

True, some advisors won't touch them. For one thing, most preferred ETFs and funds are heavily anchored in financial stocks, which have been whipsawed over the last few years. Indeed, to date most issuers of preferred stock have been financial firms.

Their stocks have mostly withered lately. "Preferred stock indices (not individual preferred stocks) cratered up to 60% during the subprime crisis," observes Louis Kokernak, CFA, CFP, a principal at Haven Financial Advisors in Austin, Texas, who avoids the space.

Even so, for all their risks, preferred ETFs and preferred funds offer plenty of benefits on the upside: high yields, good liquidity and diversification. On the ETF side, they offer lower costs.

Ultimately, choosing the right type for clients may well depend on whether you favor active or passive management.
Money has been seeping into ETFs and hemorrhaging out of mutual funds these days. Morningstar analysts agree that ETFs have been popular with investors, and Samuel Lee, an ETF analyst there, notes that some preferred ETFs such as the iShares Preferred Stock Index (PFF), managed by BlackRock Inc., have an extremely high yield. Plus, ETFs make asset allocation easier, he says.

Preferred ETFs
Preferred ETFs occupy a relatively small component of the $1 trillion-plus ETF market. Generally, preferred ETFs are benchmarked to various indexes and, like their fund counterparts, tend to focus mostly on financial preferred stocks.  
In general, preferred ETFs hold all the advantages of ETFs. They have a lower relative expense ratio that is often half that of a mutual fund, since the ETFs are not actively managed. ETFs also have flexibility: They can be bought and sold at any time during the trading day, unlike mutual funds. They offer tax efficiency because they generate low capital gains. And they offer more transparency-you always know exactly what the holdings are.

Says Kevin D. Mahn, chief investment officer of Hennion & Walsh Asset Management in Parsippany, N.J.: "You get more predictability in terms of returns, as the majority [of ETFs] are designed to track an underlying index. They're not trying to beat anything or actively manage the index; they are a passive means by which to gain exposure to a preferred stock index."

Mahn, who pens a quarterly newsletter and co-authored a book on ETFs, believes the ETF route is "more targeted and accessible" than mutual fund exposure to preferred securities.

BlackRock's iShares And Invesco's PowerShares
The two big preferred ETF powerhouses are BlackRock and Invesco. Each has its adherents.

BlackRock's iShares line of ETFs is the larger in assets under management ($620 billion) and products. Its preferred ETF product, the iShares S&P U.S. Preferred Stock Index fund (PFF), tracks the S&P U.S. Preferred Stock Index, which is 84% weighted in financials.

The fund was launched March 26, 2007 and has nearly $7 billion in assets. It has a 30-day SEC yield of 6.12%, and a low 0.48% expense ratio. The top ten holdings are all financial firms, with the exception of General Motors.

Rene Casis, a BlackRock director, citing the fund's 250 holdings, says, "For advisors it is going to provide a more diversified exposure to preferred stocks for their clients compared to competitive products, and it has the liquidity to trade intraday compared with a mutual fund that only settles at the end of the day."

One advisor who likes the ETF is Paul White, CFP, president of Independent Financial Planning Inc., an RIA in Gainesville, Va. "I use PFF and also HPS [the John Hancock Preferred Income III Fund], which is a closed-end fund for preferreds. I have more in HPS, as it has a higher distribution rate and about the same volatility as PFF. Although expenses are higher, it can be bought at a discount to NAV, and also uses some leverage."

V. Peter Traphagen Jr., CPA, of Traphagen Investment Advisors LLC in Oradell, N.J., says he includes a small allocation of the iShares S&P U.S. Preferred Stock Index fund for diversification in some clients' portfolios because its yield correlates with those of high-yield bonds. He also cites its low expense ratio, 0.48%.

Invesco has two preferred ETFs. One, the PowerShares Preferred Portfolio (PGX), tracks the BofA Merrill Lynch Core Rated Preferred Securities Index. Launched in January 2008, its assets total $1.4 billion. It has a 30-day yield of 6.96% and an expense ratio of 0.50%.

The other Invesco preferred ETF is the PowerShares Financial Preferred Portfolio (PGF), which was launched in December 2006. With $1.63 billion in assets, it tracks a separate index called the Wells Fargo Hybrid and Preferred Securities Financial Index. PGF sports a 30-day yield of 7.96% and an expense ratio of 0.65%.

Like other preferred ETFs and funds, both of these portfolios have suffered declines lately because of their heavy exposure to financials. The PGX is 83% invested in such names while the PGF is 100% invested.

Preferred Funds
There is plenty of evidence to support active management in preferred funds. Advisors have to keep in mind that their returns are tempered somewhat by greater management fees and expenses.

These funds tend not to be pure plays but hybrids of preferred stocks and other instruments. Like their preferred ETF brethren, their holdings are heavily weighted in the financial sector, which has been under pressure. Hybrid investments include floating and fixed-rate preferreds, cumulative and non-cumulative preferreds, preferred stocks with a callable or conversion feature, and trust preferreds. The asset class includes some closed-end funds, which can be purchased at a discount to their net asset value.

Consider the $455.5 million Cohen & Steers Preferred Securities and Income Fund (CPXIX), an open-end mutual fund launched in June 30, 2010 that has topped its three main ETF competitors lately. Its net expense ratio is 0.75% on Class I shares and 1.10% on Class A shares.

According to portfolio manager William Scapell, CFA, the yield of CPXIX is comparable to that of the big three ETFs: the iShares S&P U.S. Preferred Stock Index, the PowerShares Preferred Portfolio and the PowerShares Financial Preferred Portfolio.

"Compared to these three ETFs," says Scapell, "the income is similar, but depending on the share class, total return-income plus price return-has been better.

"We actually fish in a much bigger and deeper pond," he explains. "The ETFs only buy exchange-traded preferred securities, and there are a lot of preferreds listed on the NYSE, but it's a little bit less than one-quarter of the total market of preferred securities."

He continues: "The OTC preferred market in U.S. dollars is larger than the exchange-traded preferred market. In addition, there is a large foreign-currency-denominated preferred market. We have a far larger market to fish in because we buy in all these markets."

Also, Scapell says, "ETFs are not focused on fundamentals and values. They're simply buying index weights, which are derived from the market to capitalization of the securities out there. Our strategy is to focus first on the fundamentals of the companies, and then from our relative value overlay, we select the best securities from a risk-reward standpoint. By doing this, we've been able to perform better in good markets and bad ones."   

The Cohen & Steers fund's year-to-date performance as of July 31, according to Bloomberg, was 5.98% and for one year it was 12.86%. That compares to the iShares S&P U.S. Preferred Stock Index's returns of 3.06% and 5.58%, respectively, and the PowerShares Preferred Portfolio's returns of 3.45% and 6.81%, respectively.

One advisor who likes the CPXIX fund is Nicholas Laverghetta, CFP, principal of NCM Capital Management LLC in Ramsey, N.J. "I use CPXIX in my client portfolios," he says. "I believe that in the preferred area, an investor is better off with a professionally managed fund because they are different types of preferred securities and I'd rather have an expert pick and choose which ones should be in the portfolio."

The $789 million Nuveen Preferred Securities Fund (NPSAX), an open-end fund launched in 2006 just before the market crash, also has managed to do well despite its heavy weighting in financials. The fund is 95% allocated to preferred and hybrid securities, with the balance in other fixed income and cash. It has a 1.12% expense ratio.

"We invest in both the retail side of the market as well as the institutional side," says portfolio manager Douglas Baker. "On the retail side, it's easier for investors to buy and sell because of the smaller par shares, and the fact they trade on an exchange in a similar fashion to stocks."

Year to date through July 31, the fund's A shares were down 0.61%, but were up 12.263% over the past year during the same time frame.

Baker says the reason his fund has done well is because of inefficiency within the ETF market. "The inefficiency is the result of the large retail investor presence in the asset class," he says. "The retail investor does not always have access to the same resources (i.e., credit research, access to multiple broker-dealers and exchanges, etc.) as a firm like Nuveen does, putting the retail investor at a competitive disadvantage.

"The ETFs I follow in the preferred space are indexed-based, so are not actively managed, and only invest in $25 par [value] retail securities. It's actually pretty difficult to run a strategy in preferreds without a significant weight to financial services."

Interest in the preferred securities sector has sparked several new offerings. Destra Capital Management, based near Chicago, recently rolled out the Destra Preferred and Income Securities Fund, which invests in a portfolio of preferred and income-producing securities.

The subadvisor is Flaherty & Crumrine, an old-line money management firm. "We like an open-end mutual fund format as opposed to an ETF because of the active management, the in-depth credit analysis and trading expertise," says Peter Amendolair, CIO of Destra.

Naysayers
Not surprisingly, some advisors are not fans of preferred ETFs and preferred funds, citing the portfolios' concentration in financial products and other risks.

Don Martin, the owner of Mayflower Capital in Los Altos, Calif., says he avoids both.

"I think active management is the only solution. I don't trust passive investing. I have heard too many stories where some anomaly occurred that cost more than the savings in management fees."

Likewise, Kokernak of Haven Financial Advisors is not an enthusiast of either preferred ETFs or preferred funds. "I'm not a fan of preferred stock funds due to their heavy concentration in financials. "That's the nature of the beast-most preferred issuers are banks, insurance companies and the like."