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Applying Smart Beta to Preferred Stocks How does combining low vol and dividend yield influence risk/return in U.S. Preferreds?
BY Hong Xie

INTRODUCTION


Preferred stocks are hybrid securities that sit between common stocks and bonds in a company’s capital structure, therefore exhibiting blended characteristics of both asset classes. They have been favored by income-seeking investors due to the higher yields they offer in comparison with common stocks and corporate bonds.


Historically, dividends have been a dominating driver for the total return of preferred stocks. Therefore, many preferred strategies seek to capture the benefit of higher-dividend-yielding preferred stocks.


However, as with any income-oriented strategy, it is important to avoid falling into a yield trap. In particular, our research in equity dividends has shown that securities in the top quintile of the yield-ranked universe have higher volatility and lower risk-adjusted returns than those in other quintiles. Similarly, this paper shows that higher-dividend-yielding preferred stocks also tend to exhibit higher volatility, and therefore an income strategy may require some form of volatility management for prudent portfolio construction.

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