PFFA ETF: Time To Move On As Macro Risks Continue To Grow

You have to know when to hold them and you have to know when to fold them. You also have to know when to double down on a call and that is probably the most important one of the three. Within our risk management framework, there is very little room for “hand over fist” buying or getting a starry eyed view of an investment yield with poor total returns. Doubling down on anything is a rare exception. But we did double down on our buy rating for Virtus InfraCap U.S. Preferred Stock ETF (NYSEARCA:PFFA) after the earlier one in July 2022 turned out to be an exceptionally poor entry point. That paid off and PFFA is up a stunning 16.72% in about 1 month since then. It has also outperformed the S&P 500 ETF (SPY), something we suggested was likely to happen.

In fact the rally has been so spectacular that PFFA is even showing positive total returns from our horribly timed buy rating in July.

We tell you why we are downgrading this fund to a hold as we look at the evolving risks on the horizon.

The Fed

2023 can be characterized by “risk-on”. Whether it is Tesla Inc. (TSLA) rising 70% from the lows, or multiple companies destined for bankruptcy providing triple digit returns, the message is the same. We forgot about 2022 the moment we rang in the new year.

Alongside that, we also priced in the most perfect of all outcomes. A benign investing climate where CPI drops, GDP continues to grow and the Federal Reserve cuts rates. On the Fed funds rate, we have actually priced in two cuts for 2023.

This is one of the worst pricings we have seen for the market. The odds of GDP continuing to grow while CPI recedes and the Federal Reserve cuts are extremely low. Inflation is going to be dictated by costs for corporations and the largest cost for corporations is wages. Those are still moving up at brisk pace. The latest drop in the year over year numbers is due to a small drop in the 16-24 year category.

The rest continue to move higher. Overall we are running at 6.3%. Job switchers are getting a bigger bump.

The overall labor market still remains very tight.

Most disturbingly for the Federal Reserve’s ambitions, their primary gambit has not worked. Their logic was to unwind the housing bubble and cause job losses there, which should cascade and create slack in the labor market.

To their credit they hit the housing market with a sledgehammer.

Shockingly, construction jobs are not budging.

The problem is that the labor market is so tight that even homebuilders and other construction firms are not laying off. They are taking the gamble that they rather suffer through this rather than try and recruit people down the line.

In our view the two possible outcomes are clearly bad.

1) We don’t hit a recession and inflation stays above 4-5%, ultimately tracking wage growth. We should see another hiking cycle priced in this case and SPX should move to 2,800.

2) We hit a recession and the Fed starts cutting perhaps in early 2024. Our base case here is SPX 3,200.

In neither of those two outcomes we would see any of the risk assets doing particularly well.

PFFA

PFFA remains a leveraged yield play on risk assets for now. In case you don’t believe us, here is a thought exercise. One of the lines below is PFFA. Guess the other one?

It is Invesco QQQ Trust (QQQ). Would you have guess that PFFA would track QQQ so well over the last 12 months?

While we have compared PFFA and QQQ, this is actually happening systematically across the board. ETFs of all stripes have become a giant macro beta play. Individual alpha is becoming harder to generate.

So while we can debate the holdings and opine on the management expense ratio, the primary driver is increasingly where risk assets go. As we said above, risk assets look vulnerable and so does PFFA.

Verdict

PFFA has done well since inception. The fund has beaten out iShares Preferred and Income Securities (PFF), Flaherty & Crumrine Preferred Income Opportunity (PFO), Flaherty & Crumrine Total Return Fund (FLC) and Nuveen Preferred & Income Securities Fund (JPS).

PFF is an ETF while the other 3 are closed end funds. To make it an apples to apples comparison we used total return NAV metric and not total return price. The latter is influenced by changing discounts or premiums to NAV.

That good performance has come with some crazy volatility. A great way to see that volatility is to look at what the returns for this fund were just on December 31, 2022, 29 days back. The fund was actually trailing its benchmark, on 1 month, 3 month, 1 year and 3 year timeframes.

The fund carries a very high beta and that beta comes adding leverage on to junk level preferred shares.

That works when risk-assets are due to bounce and that gives you a lot of nausea when things reverse. At this point we see far more risks on the downside. We closed out multiple different preferred share and baby bond trades in our portfolios recently and we are moving to a more defensive stance as January winds down. Most of these were initiated during the heavy despondency period and are far less lucrative today. One example is shown below.

PFFA is a nice heavy beta play that might make sense down the line for another buy rating, but for now, we are downgrading this to a hold as well.

Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.