Active preferred share funds: winners and sinners
Some active managers really can enhance performance
Preferred-share funds on average have done very well through the pandemic, which began with the sharp two-month decline in February and March 2020 and continued through the end of June 2021. Funds in the category fell on average 24% in the initial selloff, sixth highest among all categories, but steamed back in the ensuing 15 months with an average return of over 57%. As of June 30, the category sits at a 17-month net return of 21% with all funds earning a positive return in the period.
Although a non-negative return is the first goal for investors, ultimately, growing investments at the best possible rate is the desired longer-term objective. One of the most important choices in modern portfolio construction is weighing the greater cost of active management against the lower cost of passive market performance.
The modern age-old question
One of the index funds available in the Preferred Share Fixed Income category is iShares S&P/TSX Canadian Preferred Share Index ETF (TSX: CPD). This ETF tracks the S&P/TSX Preferred Share Index, which provides exposure to the Canadian preferred share market. Its return through the pandemic matches the category average.
As one of the most recognized indexes representing the broad Canadian preferred market, it serves as the benchmark for many funds in the category, including the four we’ll look at here. These are all actively managed Canadian preferred funds. Two are top performers through the period, and two lag their category peers.
While it is true that all preferred funds successfully weathered the pandemic, the question is: Did active management help or hinder? In cases where it hindered, investors would have been better off just buying and holding the index. In the opposite, we might expect a skilled manager to reduce losses in the correction or enhance returns in the recovery.
Chart 1 shows how all five funds grew an investment of $10,000 from the beginning of February 2020.
Although this is a relatively short time frame (17 months), the two top funds with total returns of 31.3% and 30.6%, have clearly outperformed both the index (20.2%) and lagging peers (average 17.3%). Somewhat surprisingly, they did not suffer any less in the February-March correction. In fact, both top funds declined more than the benchmark. What solidified their position at the top is their subsequent performance in the recovery.
Data dive reveals performance secrets
Table 1 digs deeper into the returns and fund holdings, summarizing the degree of active management, the associated cost and performance hurdle, and the excess return generated over the index, as developed by Dr. Martijn Cremers. For a refresher on how these data are calculated, please see my previous article on active management analysis.
Although at 66%, it has the second-lowest active share of the four funds, the top-performing TD Active Preferred Share ETF (TSX: TPRF) has an MER of 0.51%, barely above the index, resulting in effectively no performance hurdle and dropping any performance better than the index straight to the bottom line. That excess performance happens to be a healthy 8.46%. The fund successfully combines the best traits of passive management (low cost) and active management (excess return) to deliver a best-in-class product that successfully navigated the pandemic for investors.
Similarly, Purpose Canadian Preferred Share Fund (NEO: RPS) returned an annualized 7.3% in excess of the index. That was pared by a hurdle rate of 1.6%, higher on account of its 1.67% MER. The higher MER, however, may be justified by an active share of 73%, the highest of the group. In terms of net excess return (excess return less the hurdle rate), the fund active management finishes a few percentage points behind TPRF, but this is only a small sample meant to look at a specific period of time and may not reflect the trend in the long-term.
That goes for both Trailing Funds (TF1 and TF2) as well, which I am using for illustrative purposes only, and have not identified by name. Although it is a small sample size overall, we can examine the breakdown of the performance of these two funds through the pandemic and identify some potential factors that influenced their performance.
Interestingly, both TF1 and TF2 arrive at similar net-negative excess returns (-2.91% for TF1 and -3.03% TF2) but for different reasons. In the case of TF1, a high MER (<2%) and large overlap with the index (52%) results in a high cost of the actively managed portion of the portfolio (3.41%) and subsequent performance hurdle (2.91%). With no excess return over the index, the performance does not justify the additional cost and reduces overall returns.
On the other hand, TF2 has a much lower MER (<1%) and high active share (71%), which produces a lower cost of active management (1.05%) and subsequently lower hurdle rate for the active portfolio (0.55%). These are positive attributes when combined with a positive excess return; however, a fund is not rewarded for simply being actively managed. If active management is creating headwinds for returns, it matters little how cost effective it is.
On a final note, I just want to quickly touch on is “length of conviction,” another important aspect of active management, which is proxied by the weighted average holding duration. I did look at that for each fund, but given the short time frame, it did not seem especially relevant. All durations were relatively similar, differing only by a few months. The index itself actually had the highest duration for the period at about 15 months.
Notes and Disclaimers
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