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An ETF solution to the preferred share quandary

 Gordon Pape is a well known investing and personal finance guru and author, 2009

Tory Zimmerman/The Globe and Mail

With bond yields near record lows, income investors have been hard pressed to find low-risk securities that generate the cash flow they require.As Christopher Antony of CIBC Wood Gundy's Investment Strategy Group noted in a recent report, the FTSE TMX Canada universe bond index was yielding just 1.7 per cent at the time while the S&P/TSX composite index was at 2.9 per cent. Meantime, the preferred share universe index yielded a very attractive 5.4 per cent.

So why aren't more people putting their money into preferreds? Some are, but many more are licking their wounds from the hammering that reset preferreds, which make up about 60 per cent of the market, have experienced in recent years. They're frightened, understandably, to throw more money at what they see as a sinking ship.

Reset preferreds are a relatively new phenomenon and their brief history has not been good. These stocks pay a fixed return for a certain period, usually five years, after which the rate is reset using a formula that is tied to a key rate such as prime. They work best in a rising-interest-rate market. Unfortunately, rates have been falling almost from the day the first resets came out. The result has been losses of up to 40 per cent on key issues. No wonder people are frightened.

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Moreover, building a preferred share portfolio on your own is difficult and time-consuming. These shares are not well covered by analysts and brokers rarely recommend them, except when they're pushing a new issue. The overall market in Canada is small and difficult to analyze. As a result, most people look elsewhere.

However, here is a possible solution to the preferred share quandary: the Horizons Active Preferred Share ETF, which gained 16.77 per cent over the six months to the end of August and yields 4.4 per cent at the current price. Here are the details.

Horizons Active Preferred Share ETF

Type: Exchange-traded fund

TSX trading symbol: HPR

Current price: $8.28

Annual payout: 38.8 cents

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Yield: 4.4 per cent

Risk rating: Higher risk

The security: Most ETFs are passive securities. That means they closely track their target indexes and the returns reflect what that market is doing. However, this ETF is actively managed, which means the team at Fiera Capital decides on the composition of the portfolio. They invest mainly in Canadian securities, but the ETF may also hold some U.S. stocks. Non-Canadian dollar exposure is hedged.

Why we like it: Active management means the administrators can minimize their positions in the riskier segments of the preferred share market, which is about 60 per cent weighted to resets. As a result, while this fund has not been immune to losses, it has fared better than the more widely held iShares S&P/TSX Canadian Preferred Share Index ETF (CPD) in recent years. For example, this fund lost 12.67 per cent in 2015, compared with 15.25 per cent for the iShares entry. The one-year gain to Aug. 31 was 4.45 per cent, compared with 1.94 per cent for the iShares ETF.

Assets: The Horizons fund has assets under management of almost $790-million. That compares with about $1.2-billion for the iShares fund.

Risks: The preferred share market has settled down since the start of this year and has been on an upward trend in recent months. However, these securities are highly interest-rate sensitive.

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A sustained upward movement in rates would have a negative effect on the price of this fund.

Distribution policy: The units currently pay 3.237 cents a month (about 38.8 cents a year) to yield 4.4 per cent at the current price.

Tax considerations: Distributions are treated as a combination of return of capital and eligible dividends. The percentage of each will vary from year to year. In 2015, HPR investors received 87 per cent of their payments as dividends, with the rest qualifying as return of capital.

Cost: You'll pay a brokerage commission to buy or sell unless you have a fee-based account. The annual management fee is 0.55 per cent plus applicable sales tax.

Who it's for: This ETF is suitable for investors who are searching for yield and can handle the risk involved in today's complex preferred share market.

How to buy: The units trade actively on the Toronto Stock Exchange. Any broker can fill your order.

Consult your financial adviser before making any investment decision.

Gordon Pape is editor and publisher of the Internet Wealth Builder and Income Investor newsletters. For more information and details on how to subscribe, go to buildingwealth.ca.

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