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From bottom performers to topping the tables

The story of preference share funds.
The performance of these funds over the last three years shows quite clearly that the returns in any year are no indication of what will happen in the next. Image: Shutterstock

For the year to the end of November, the FTSE/JSE All Share Index (Alsi) was down 12.26%. The FTSE/JSE Preference Share Index, by contrast, had gained 13.12%.

This is a dramatic reversal from 2017. Last year, the Alsi gained 20.95%, while the Preference Share Index fell 3.29%.

This poor return from preference shares on the JSE in 2017 was extremely challenging for local preference share funds. The CoreShares Preftrax exchange-traded fund (ETF) was the year’s worst-performing ETF.

The two local unit trusts that focus on preference shares – the Nedgroup Investments Private Wealth Preference Share Fund, and the Bridge Diversified Preference Share Fund – also produced disappointing overall returns. The Nedgroup Investments fund was marginally positive for 2017, but the Bridge portfolio ended the year down.

Uncorrelated returns

One of the greatest benefits of preference shares is however that their performance tends to show very low correlation to that of the stock market. This has been clearly illustrated over the last three years.

As the table below shows, the returns from the Preference Share Index and the Alsi have differed noticeably since the start of 2016.

Total index returns
  2016 2017 2018 YTD
FTSE/JSE All Share Index 2.63% 20.95% -12.26%
FTSE/JSE Preference Share Index 18.81% -3.29% 13.12%

Source: Morningstar

This illustrates how preference shares can add meaningful diversification benefits in a balanced portfolio. They tend to deliver strong returns when stock markets are weak.

This has very much been the case in 2018. From being among the worst-performing funds last year, preference share funds are topping the performance charts for 2018. Both the Nedgroup Investments Private Wealth Preference Share Fund and the Bridge Diversified Preference Share Fund showed returns of over 15% to the end of November.

The chart below shows how, over the last three years, their performance has consistently diverged from that of the Alsi.

Source: Morningstar

Income

The other great benefit of preference share funds is that they tend to produce a consistent and reliable dividend income. The Bridge unit trust delivered a yield of 9.93% over the past 12 months, while the yield on the CoreShares Preftrax has been 10.67%.

Investors will receive this income regardless of the price movements of the underlying shares. Reinvesting the dividends compounds returns for long term investors, but can also be a useful part of an income-producing portfolio post retirement.

This is because these distributions are taxed at the dividend withholding tax rate of 20%. This is lower than the income tax rate for anyone in anything other than the lowest tax bracket.

Market cycles

The varied returns in these funds over the last three years is also a good lesson for investors who think they can spot a coming year’s top performers. They show quite clearly how one year’s returns are no indication for what will happen in the next.

It is not that unusual for the bottom performers one year to be the top performers the following year. That is exactly what has happened with preference share funds from 2017 to 2018.

Similarly, if anyone had invested in preference share funds at the start of 2017 based only on their strong performance in 2016, they would have been deeply disappointed. They would probably also have sold out at the bottom and missed the strong rebound this year.

What is far more important than just looking at performance numbers is understanding how different funds generate those returns. That helps you to understand how they can fit into a diversified portfolio and what you can expect from them in future.

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Benjamin Graham in his book (The intelligent investor) states that he feels that preference shares are a “worst of both worlds” situation. You don’t have the security of bonds, and you don’t have the growth/profit potential associated with stocks. So yeah I remain cautions regarding preference shares, they look awesome on the surface but the reality is not that great in my opinion.

I was thinking of the same thing.

Does the book not go on to say Pref Shares with no conversion rights is the issue rather than just Pref Shares generally… I also recall that perhaps the right of Pref holders to control the company in the event of trouble should also be considered. Or maybe I’m extending a concept of bonds. In any event, perhaps the specific terms of the prefs concerned should be considered. For, as they also mention in the book, it is not the name of the instrument that matters, but what the holder can realistically expect to lay claim to because of holding the instrument.

🙂 🙂

Is this a repeat of the 2015 market correction/crash?

1) US – China trade war,
2) US FED rates increase,
3) Talk of recession in the US by 2020,
4) Economic slowdown in China,
5) Economic slow down in the US in 2019,
6) Brexit – no deal,
7) France riots, Hungarian riots,
8) Goldman Sachs getting sued by Malaysia,
9) Ukraine/Russia tensions

..missed a few

Saudi/Yemen/UK/US war currently ongoing
Turkey/YPG war in Syria starting this week

The US is always at war

and lets add a solar flare hitting earth

Thanks Patrick, ‘diversification the only free lunch in finance’ and preference shares certainly have their place in a diversified income portfolio – especially for high tax payers.
Would be good to see new issuers come to market and for the asset class to solidify itself in the SA capital markets landscape. I suspect yields need to move lower first..
The yield is still good despite a stronger year this year.
Info on PREFTX: https://coreshares.co.za/products/coreshares-preftrax-preftx/

Gareth Stobie, CoreShares

Sheesh, a yield greater than your withdrawal rate as a retiree – now that’s a great deal!! You’ll probably end up not touching the capital, live off the yield, be able to increase it by inflation each year 🙂

Pref shares started going out of fashion when the Repo rate fell from 11,5% round about 2008 and the introduction of dividend tax.
From about 2011 pref shares lost about 30% in value but now seem to have stabilised at an annual dividend of about 10% pa.
At a 25% discount to their issuing price the current levels earn very nice dividends.

Shhh Patrick! Prefs are terrible, please dont buy them 😉

The preference share index is dominated by ZA banks, so you may not be diversifying as much as you think.
A way to value preference shares might be to consider them as an perpetuity (i.e. sum of all future dividends). Sensitive to discount rate but does give a nice framework to think about the valuation.

Informative article. Anyone know what the Pref market cycle is going to look like for 2019? From all accounts and as we are entering long term bear territory, it should be good? I for one would be happy for a 10% return but you can get that on cash anyway can’t you so why would you put your money into Prefs and take a gamble on the cycle?

Tax . 20% versus up to 45% for income. And taking pref dividends does not jump you into the next higher bracket if you are below the 45% band.

End of comments.

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