ETF PFFA: exceptional trading, not enough to offset macro headwinds

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When we review an ETF, we pay close attention to the macro environment. Although we look at other factors, macro still trumps everything else for us. Indeed, even the best managers will struggle swim against the current. For example, if you bought an energy fund in 2014, there was no chance you would get positive returns 1 year later. It didn’t matter who you chose as your manager. Our one-year macro outlook predicted a massive surge in yields and substantial credit stress in 2021, so it was very easy to make negative calls on popular funds. Whether it’s popular treasury bond funds like TLT or closed-end funds like PIMCO Income Strategy Fund (PFL) and PIMCO Corporate & Income Opportunity Fund (PTY), we were happy to slap the sell ratings. While those calls went well, we’re having one today where the manager certainly swam against the tide a lot and made us rethink our decision.

Our call

When we covered Virtus InfraCap US Preferred Stock ETF (NYSEARCA:PFFA) in September 2021, we gave it a good chance to cut its distribution.

Based on all the information we have reviewed, PFFA has a “high” level of dividend cut risk on our proprietary Kenny Loggins scale.

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Kenny Loggins scale (trapping value)

This rating signifies a 33-50% chance of another dividend cut over the next 12 months.

Source: Schrödinger distributions, 3 high yields likely to reduce

Now, September 12, 2021, if you left the fund and came back today, you would definitely treat us to dinner. The net asset value of the fund is down 8.72% and even the total return is negative 3.75%. So you’ve definitely won by using the caution we’ve suggested.

PFFA ETF Price
Data by YCharts

This part was to be expected as investors had never shown such blatant disregard for restraint in the hunt for yield as they did then. We knew the piper would have to be paid when investors jacked up premiums on PIMCO funds up to 5-8 years of after-tax distribution returns. For us, PFFA was exposed to the same risks as it was a leveraged fund hunting an interest rate sensitive asset class at potentially the most dangerous time. Nevertheless, we have been very impressed with what has happened so far. PFFA easily beat iShares Preferred and Income Securities (PFF) by around 7% in total returns.

ETF return PFFA
Data by YCharts

PFFA uses leverage and lots of it. Showing such huge alpha in a downside is generally unheard of for leveraged funds. PFFA also brought other leveraged funds to the cleaners in the same time frame. We have featured Flaherty & Crumrine Dynamic Preferred and Income Fund (DFP) below as our leveraged preferred share fund. Here, we’ve compared movements in NAV so that changes in the discount and premium of this closed-end fund won’t cloud viewers’ eyes. We also added PTY, which is a bond fund, but was under the same level of stress.

PFFA Yield ETF and DFP
Data by YCharts

These results stand out again, especially when many consider PTY to be the best fund ever created to manage high-yielding assets.

What did PFFA do well?

PFFA returns can be attributed to two main factors. The first is concentrated bets on its major holdings. This paid off when its price-sensitive preferred stock South Jersey Industries, Inc. UNIT 04/01/24 (SJIV) benefited from the acquisition of South Jersey Industries, Inc. (SJI).

Back to SJIV

SJIV Chart (Seeking Alpha)

We should also add that we had suggested that this very issue was quite risky as there was a definite conversion coming up and PFFA was in danger of being hit if SJI overturned. PFFA took that bet (in large quantities, we might add) and came out on top.

The second reason was exceptional transactions made by the managers. We saw it in the huge turnover during this period, as the top 10 holdings were regularly replaced by new faces. PFFA has also been emphasizing holdings with very high coupon rates during this period and these have been significantly less impacted by duration compared to some other names held in PFF.

Perspectives and verdict

The main objective of the Federal Reserve is to establish its credibility and until April 22, 2022, it seemed that it was failing. The market throws down the gauntlet and tells them they don’t buy the warmongering rhetoric. Inflation thresholds actually rose last week, showing that the Federal Reserve needs to do a lot more.

Breakeven rate of inflation over 5 years

5-year equilibrium inflation rate (Bloomberg)

Even the perma-bond-bull camp is in panic mode over inflation.

Should the Fed cease its efforts to calm inflation before it has been fully brought under control, bond investors should be wary.

Source: Hoisington

It comes from the group who thought staying fully invested in 0.5% 10-year Treasury yield bonds was a brilliant idea.

Although we believe we are close to the highest inflation rates year over year, the Shanghai lockdown has the potential to keep inflation uncomfortably high. This backup, for example, will take months to complete.

Ships awaiting loading or unloading in Shanghai

Vessel value (Rich Bernstein -Twitter)

Therefore, we think there will likely be even more aggressive surprises from the Federal Reserve and we would be cautious in general on leveraged ETFs. The commercial record at this point, however, relieved much of the pressure of a possible reduction in distribution. If the NAV were down 15-20% from the 8.72% we saw, we would back our call for the distribution cut. But as things stand, PFFA is swimming furiously against the tide. Two thumbs for performance.

About Meredith Campagna

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