Older investors looking for a steady stream of tax-efficient income may want to consider a preferred shares ETF. These funds combine the simplicity of an ETF with the possible upside of an actively managed fund – although liquidity and volatility remain a factor.
How are preferred shares ETFs different from other ETFs?
Exchange-Traded Funds are an immensely popular investment vehicle because they offer an easy way to participate in the markets, for what most investors consider low fees.
But for those who want the chance to do more than match an underlying index without risking the farm, specialized ETFs, such as those trading in preferred shares, may be the way to go.
This type of boutique ETF would be best suited for older investors who would like to take advantage of the income and tax advantage of preferred shares without necessarily having the extensive knowledge needed to pick the right ones.
“With preferred shares, you need to know what you’re doing – some of them are complicated and confusing (and) the liquidity on them is not necessarily ideal,” said Doug Grieve, chief investment officer with Slater Asset Management Inc.
“A preferred shares fund would be managed by someone who can access ways of getting liquidity probably better than the individual, and can also give the investor access to dozens of preferred shares issues that are pooled together.”
That could result in more diversification and lower liquidity risk, because the investment would be based on professionally hand picked stocks.
Benefits and drawbacks of preferred shares
Preferred shares are a bit of a hybrid asset class – they’re a fixed income product but they trade like equities and can be bought and sold on an exchange. They also provide a dependable cash flow with a built-in tax break because they qualify for the Dividend Tax Credit.
While this type of stock doesn’t give a shareholder voting rights, it does pull rank in a crisis. If a company were facing bankruptcy, preferred shareholders would get paid before those holding common shares.
The performance of these types of shares is largely driven by interest rates, not how well a company does.
This can result in unexpected volatility at times – like when the Bank of Canada surprised financial markets with a 0.25 per cent rate cut in 2015, causing holders of fixed reset preferred shares to worry that fixed reset preferred dividends would be reset to unacceptably low rates.
That’s why purchasing preferred shares within an ETF structure can help investors get around some of the intricacies that come with this type of stock when it’s handled on an individual basis.
“It takes away the complexity – the investor is buying just one product that gets high yield, a monthly distribution that’s tax efficient,” said Grieve, who specializes in preferred shares.
Who would a preferred shares ETF be well suited for?
The ideal investor for this type of fund would be someone 55 or older who is looking for capital preservation.
It’s also a good fit for people with a low to moderate risk threshold who want their taxable money to generate an income that they can live off.
And while preferred shares tend to have more volatility than investment vehicles like GICs or government of Canada bonds, they also tend to provide better returns after taxes.
“It’s an income alternative,” said Grieve.
“You don’t want to put all your money into preferred shares, but certainly to increase some of that income without huge risk a good allocation to preferred shares is a good thing for a fixed income client.”