Investments make money in one of three ways – dividend income, capital gains or interest. When investing in a debt instrument, income from interest (sometimes called coupons) is what you can expect. This week’s featured ETF is a good option for investors who hope to earn an income from their investments. The CoreShares Preftrax ETF tracks the Preference Share Index.
What are preference shares?
Preference shares are a way for companies to borrow money. They are different from ordinary shares, because they don’t grant voting rights. Shareholders also don’t make money from share price movements, as is the case with ordinary shares. Instead, the company agrees to pay interest and return the initial investment amount after a period, like with bonds. The interest received on these shares are linked to the prime interest rate. Interest is paid to preference shareholders before dividends are paid to ordinary shareholders. If the company goes out of business, preference shareholders get back their capital before ordinary shareholders do. If, however, the company also issued bonds, bondholders will get paid before preference shareholders.
Preference shares allow companies to raise money at a reasonable rate without having to give up ownership. Sometimes companies have a right to buy back these shares when funding is no longer necessary.
TIP: Interested in the inner workings of preference shares? In this podcast, Simon Brown talks to Eugene Chemaly from Afrifocus about these products.
The CoreShares Preftrax ETF is invested in 17 preference shares. The ETF is weighted by market capitalisation, which means it invests more in larger companies. While this ETF offers a high dividend yield, it is heavily invested in banks and financial services providers and has a relatively high TER. Although preference shares could be considered a safer income option, its high exposure to the banking sector could become problematic if the sector takes a hit.
Weekly expert: Keith Mclachlan
Every week, we ask an independent industry expert to unpack our featured ETF. This week, Keith McLachlan from AlphaWealth discusses the pros and cons of this ETF and offers advice on what type of portfolio would most benefit from this holding.
What sets the Preftrax ETF apart from other ETFs?
The uniqueness of the index it’s tracking is probably the key defining feature: the FTSE/JSE Preference Share Index (J251). This index is pretty much a market cap weighted index of the non-convertible, floating-rate perpetual preference shares. Preference shares structured like this are essentially permanent debt instruments that pay out “dividends”. It is probably best to simply view these instruments as loan earning interest that, via the ETF, will compound.
What limitations should investors be aware of?
The majority of these preference shares in the underlying index are banking-related, for example, Standard Bank, FirstRand, Absa, Nedbank and Investec collectively make up a whopping 75.26% of this index! Therefore, the underlying is quite sensitive to not just interest rates, but also a Sovereign Rating Downgrade, as no bank is allowed to have a credit rating above that of the Government in which jurisdiction they operate.
What type of portfolio would most benefit from holding this ETF?
This is a yield play with zero capital growth other than via reinvesting yield, therefore this is for the yield-seeking investor with an appetite for something different and willingness to take a large exposure to SA banking sector credit risk.
Featured on the Just One Lap ETF Blog by Kristia van Heerden