Is SA’s worst-performing ETF really so bad?

Over the last five years the price of the CoreShares Preftrax ETF has fallen from R10.71 to around R7.90. This is a decline of over 26%.

In 2017 alone, the price of this pref share ETF fell 11.4%, making it the worst performer for the year. It was particularly hard hit in December, given that Steinhoff pref shares made up 4.8% of its portfolio.

Those numbers don’t look particularly good for investors. They suggest a rather large loss for those who have held the fund for this period.

However, most investors in pref shares are not looking for long-term capital growth. Their focus is instead on the dividend yield, and so the price of the CoreShares Preftrax ETF only tells part of the story.

The fund is currently offering an effective yield of between 10.68% and 11.30%, depending on whether or not the Steinhoff shares pay out. Even after dividend withholding tax, that is a yield of over 8.5%, which is a lot better than you can get from cash.

Despite the significant slide in its price last year, the ETF delivered a total return of -2.79% with dividends reinvested. This is obviously still not very good, but it shows how stripping out the dividend can distort the picture.

Over five years, reinvesting the dividends would actually have produced a positive return for investors of 2.29%. Again, that is poor, but it’s also not negative.

Consistent income

“The pref share market is really for an investor looking for a reliable source of income,” says the MD of CoreShares, Gareth Stobie. “Regardless of its pricing, the income from the asset class is very reliable.”

As the chart below shows, the annual distributions from the CoreShares Preftrax ETF have stayed relatively constant in absolute terms over the last five years, despite the changes in the underlying price. As interest rates have moved slightly higher from 2015, so distributions have also risen to compensate.

Source: CoreShares

“This is a very useful solution for someone building an income portfolio, particularly if the client is tax sensitive,” says Stobie.

This is because the payout is taxed as a dividend. Withholding tax at the current rate of 20% is well below the top personal income tax rate of 45%.

Since pref shares are variable-income instruments, investors also don’t take any interest rate risk. As the prime rate goes up, dividends will shift higher, but unlike bonds, this higher yield does not automatically mean that the pref share’s price will go down.

While this does give investors a good way to diversify their income strategies, it does also have a negative side.

“These instruments are perpetual, which means that when a company issues a preference share there is no undertaking to repay the capital,” Stobie explains. “So what drives the price is demand and supply in the market, and sometimes the local market can be fairly illiquid. Our experience is also that that the supply and demand dynamic for pref shares on the JSE can be very irrational.”

Market dynamics

An indication of this is that the general decline in pref share prices over the last five years has not always been easy to explain. There are however a number of factors that have had an impact.

The first is increased risk aversion towards the asset class due to the failure of African Bank, and that has now been heightened with the issues around Steinhoff. In addition, since many pref share investors are looking for the tax benefit, the introduction and subsequent increase in dividend withholding tax has made these instruments less attractive.

“There’s also been quite a lot of discussion around the changing bank regulations and where pref shares sit within a bank’s shareholding structure from a capital adequacy ratio perspective,” says Stobie. “When banks initially issued pref shares, they qualified as tier 1 capital. That benefit to the banks has however now been eroded.”

Some banks have therefore been buying back their pref shares, which is reducing market liquidity.

Another drawback with pref shares is that, similar to bonds, investors do not see the long-term capital growth they would get from shares or listed property. The income stream therefore doesn’t grow sustainably as it would from dividend-paying equities or Reits. Craig Gradidge of Gradidge-Mahura Investments says that this is one of the reasons that they don’t use this solution for their clients.

“Pref shares have delivered reasonably good income, but over time investors are better off earning dividends from equities as they benefit from compounding as companies grow their profits over time,” Gradidge says. “Income from prefs is linked to the interest rate cycle so compounding is limited to investors reinvesting their income.”

Pref shares do however offer a diversification benefit relative to growth asset classes. The pref share market often moves quite differently to listed equities.

The last two years have been an excellent example of this. In 2016, when the JSE had a very weak year, the CoreShares Preftrax ETF was up 17.7% for the year. When the JSE rebounded in 2017, however, preference shares slipped.

“It’s an asset class that thrives when general equity markets are poor, so there is pretty low correlation,” explains Stobie. “So by including pref shares in a balanced portfolio, you are balancing out the risk dynamics.”

Brought to you by Moneyweb