SWAN Income For Turbulent Times: Virtus InfraCap U.S. Preferred Stock ETF

ETFS

A few months ago, I ran across an intriguing opportunity – a real estate-related exchange-traded fund (or ETF) – that I’d like to share with readers, subscribers, and members alike.

It’s an investing concentration I’ll admit I don’t write about very often. So far this year (excluding this article), I’ve only published two pieces on it:

  1. Selecting the Best ETF in This Coronavirus World” on March 27
  2. No REIT ETF Is Pandemic-Proof, but These 3 Are Close” on April 8.

Before that, the last time I touched the topic was as a year-end recap story on Dec. 21, 2019. “A Banner Year for Real Estate ETFs” included the following points:

  • “More than $5 billion has poured into U.S. real estate EFTs this year.”
  • “‘Goldilocks’ economic conditions of low interest rates and steady, domestic-led economic growth have been an ideal backdrop for commercial and residential real estate equities.”
  • “Innovation in the real estate ETF space has enabled investors to customize their portfolios more specifically to their needs, objectives, and existing exposures.”

And then it featured this paragraph in the intro:

“While the real estate sector has taken its foot off the gas pedal a bit over the last few months, 2019 will likely still go down as [a] banner year for the U.S. real estate sector…”

All put together, it was “the best year for inflows since 2016, coming after $2.6 billion in outflows last year.”

Room to Grow

Doesn’t all that data make you just want to sigh over “the good old days?”

Oh, 2019. We took you for granted while you lasted, and then you went away, never to come back again.

On the plus side, 2020 will find that same fate in another six months. At this rate, I don’t see many of us feeling all that nostalgic about it. It’s been a pretty difficult year, to say the exceptionally extreme least.

However, that doesn’t mean we can’t grow from it in a variety of ways while it lasts.

As I’ve been busy demonstrating for months now – ever since the pandemic panic hit, really – there are still ways to profit out there. In fact, the severely reduced market gains we saw back in March offered intensely profitable openings for those who dared take them.

And while the markets have rebounded since those painfully-profitable (or profitably painful) opportunities, we’re still looking at plenty of deals.

Just as long as we manage to avoid the landmines lying around us, of course.

With that in mind, I’m not advising all-around extreme caution (just all-around extreme due-diligence, as I always do). But now certainly isn’t a time to be playing around with too much risk.

That’s why I’m turning back to ETFs today. To quote my March 27 article:

“Generally speaking, our main issue with index funds is how you end up buying and/or selling the good with the bad – some expensive shares with others that are cheap – and ones with wonderful, forward-looking growth prospects along with those that are facing growth headwinds.

“That’s why we normally stick with individual stocks instead, picking and choosing accordingly. Though that doesn’t mean we don’t understand the appeal of ETFs.

The appeal is actually quite obvious.

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Warren Buffett Likes ETFs Too Under Certain Conditions

To continue quoting from that REIT ETF-focused article:

“A desire for broad diversification is crucial to a long-term healthy portfolio. And why not want it all wrapped up in a single, easy-to-own asset?

“If that’s your point of view, that’s fine.”

With one caution:

“Just don’t get caught paying outsized fees for such diversification.

“There are numerous, very liquid ETFs that offer very low fees of just a handful of basis points. And we’re not the only ones to say nice things about these assets.”

By that, we meant Warren Buffett has mentioned index funds before. Specifically, he advised trustees to put 10% of the cash they’re managing “in short-term government bonds and 90% in a very low-cost S&P 500 index fund.”

That’s what he told both his family and Berkshire Hathaway (BRK.A) (BRK.B) shareholders (as shown in his 2013 letter to the latter). His rationale was that the long-term results would “be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.”

So there you have it from us and from one of the richest men in the world who reached that place of power because of his investment prowess.

Again, even the best ETF won’t make you rich overnight. (Then again, very few worthwhile investments will.) And you won’t get the same kind of growth potential as you would through a regular REIT.

But the exchange-traded fund below still has the makings of a profitable portfolio play we’re happy to talk about.

With that in mind, meet the Virtus InfraCap U.S. Preferred Stock ETF (PFFA).

PFFA seeks current income first and foremost, with a secondary focus of capital appreciation. It does both through a portfolio of over 100 preferred securities issued by U.S. companies with market capitalizations over $100 million.

The Virtus InfraCap U.S. Preferred Stock ETF

The fund offers the potential for attractive yields while pursuing compelling total-return results.

It believes the benchmark S&P U.S. Preferred Stock Index has recurring and exploitable structural inefficiencies. Therefore, the actively-managed PFFA bases its security selection and weightings on a number of quantitative, qualitative, and relative valuation factors.

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Source: Yahoo Finance

That’s how it deviates from the above-mentioned index, evaluating potential investments for their:

  • Competitive positions
  • Perceived abilities to earn high returns on capital
  • Historical and projected stability and reliability of profits
  • Anticipated ability to generate cash above their growth needs
  • Access to additional capital.

The fund also generally underweights or entirely eliminates callable preferred securities that exhibit a low or negative yield-to-call ratio. And it applies leverage to potentially enhance portfolio exposure further.

Almost half its positions are in REIT preferred stock, with about 25% allocated to equity REITs and about 20% to mortgage REITs.

Preferred stock prices – particularly REIT preferred stocks (actually REIT stocks in general) – were dislocated throughout the shutdown-specific market crisis. Fears abounded that tenants would stop paying rent, thereby leaving mortgage REITs unable to de-lever to save their balance sheets.

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Dividend suspensions also loomed over the REIT universe. Though, to their credit, several equity examples have demonstrated resiliency.

One such was Braemar Hotels & Resorts Inc. (BHR), which invests primarily in high revenue-per-available-room (RevPAR) luxury hotels and resorts. In today’s environment, Braemar should fare better than urban convention hotels.

The REIT did suspend its common dividend. That was inevitable considering widespread and long-lasting hotel closures (with many still shut down). However, it maintains $160 million in cash with only $80 million of corporate debt on its balance sheet.

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Plus, it’s continued paying dividends on its preferred stocks, BHR-B and BHR-D, which PFFA’s portfolio devotes about a 3.7% position to.

More to Say About PFFA

Moving on to mortgage REITs, their outlook was equally poor in March and April. Again though, many mortgage REITs stayed strong regardless.

One of those admirable companies was MFA Financial, Inc. (MFA). It primarily invests in residential mortgage assets – on a leveraged basis – including mortgage-backed securities and whole loans.

The company has de-levered its balance sheet and raised capital, making its dividend more sustainable. Although MFA did suspend payouts on its preferred stock in March, it announced last month that it would pay the accumulated unpaid amount.

That’s a good sign and one more reason to think highly of PFFA, since about 2.9% of its portfolio is in MFA preferred stocks. Clearly, it knows how to pick ‘em.

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In short, the pandemic panic has caused preferred stock prices across the platform to plummet – regardless of the high-credit quality of their issuers. Hence the reason why their market environment was so abnormal last quarter.

Especially extreme volatility persisted from the end of Q1 into the beginning of Q2. Market inefficiencies impacted liquidity, pricing, and investor sentiment. And preferred securities traded dramatically below par value.

Yet PFFA favors securities with higher credit ratings and market caps, a strategy that strengthens its portfolio during market instability.

Last but not least, the fund excludes issuers in certain preferred securities – ones that may not adequately recover from current market conditions due to low-quality assets or lack of liquidity.

A gradual return to normal business activity and more stable market conditions will likely drive preferred stock prices closer to par value. And with it, PFFA.

One last thing worth noting is how I’m now long on PFFA, which was yielding 8.2% at last check (expense ratio for PFFA is .80%).

Author’s note: Brad Thomas is a Wall Street writer, which means he’s not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free: written and distributed only to assist in research while providing a forum for second-level thinking.

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Disclosure: I am/we are long PFFA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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