The market has evolved considerably, but passive ETFs have not adapted. We believe active strategies that invest across the entire market are a better solution.
KEY TAKEAWAYS
- The indexes that passive ETFs track fall short of representing the preferreds universe, limiting potential returns.
- Active strategies provide access to the broad preferred market, enhancing diversification and risk management while capturing varied income sources.
- Active managers can potentially further add value by leveraging significant differences across preferred markets, security structures and quality.
Investors’ desire for income has led to increased interest in preferred securities, which offer attractive (often tax-advantaged) income from high-quality issuers. However, as investors look to access this dynamic market, we believe passive exchange-traded funds (ETFs), while popular, are fundamentally flawed.
A closer look at some of the largest passive ETFs (representing approximately 45% of the category’s total assets) indicate the challenges investors face when selecting passive over active. Most of these passive funds are concentrated in exchange-traded preferreds, a small (and shrinking) share of the preferreds market. They largely ignore two significant parts of the market—over-the- counter (OTC) preferred and contingent capital securities (CoCos) (Exhibit 1).
Four of the largest five passive funds have no allocations to OTC preferreds. None of the five include CoCos, which are high-yielding securities widely issued by financial institutions outside of the U.S. to meet capital requirements. CoCos have been the fastest-growing preferreds segment and now compose nearly a quarter of the market (up from just 2% in 2011).
EXHIBIT 1
Most passive ETFs disregard the largest preferreds opportunity sets
Allocations by preferred security category for popular passive ETFs
At December 31, 2024. Source: Morningstar Direct, Cohen & Steers.
Past performance is no guarantee of future results. The information is for illustrative purposes only and does not reflect the performance of any fund or account managed by Cohen & Steers. Figures may not sum due to rounding. See endnotes for index associations, definitions and additional disclosures.
Why markets matter
Preferred securities are available in a variety of structures, including fixed-rate, resettable-rate and floating-rate coupons, which results in a wide range of security duration (i.e., interest rate sensitivity). Generally, a higher duration leads to a greater price change in response to a given change in the security’s yield—an unattractive feature in rising-rate environments.
Fixed-rate perpetual securities dominate the exchange-traded $25 par preferreds market. Consequently, the duration profiles of passive ETFs (which mainly track the exchange-traded market) tend to be much higher than the average durations of funds with more OTC exposure, where most securities have coupons that periodically adjust. The exchange-traded market also currently offers the lowest average yields in the preferreds market (Exhibit 2). Yields (and credit spreads) are generally more attractive in the OTC market today.
Global preferred securities (excluding CoCos), denominated in currencies other than the dollar, are one preferred variety overlooked by passive ETFs. These securities primarily trade in the OTC market and represent approximately 30% of global preferreds. Similar to their U.S. dollar counterparts, these securities typically have fixed-to-reset coupon structures and long or perpetual maturities. Coupon payments can be deferred without triggering an event of default; however, they typically cannot be omitted and must be repaid prior to maturity or redemption.
CoCos are also unavailable to most passive ETFs. These OTC-traded fixed-to-reset securities will write down or convert to common stock in the event that the issuer’s capital level falls below a particular threshold or if the bank reaches a point of nonviability. However, such write-downs are rare, and CoCos typically offer excess compensation in the form of higher yields relative to other parts of the preferreds market and other fixed income segments.
EXHIBIT 2
OTC and CoCos markets offer opportunities unavailable to most ETFs
Composition of the preferreds market
At December 31, 2024. Source: Bloomberg, ICE BofA, Cohen & Steers.
Past performance is no guarantee of future results. The information presented above does not reflect the performance of any fund or other account managed or serviced by Cohen & Steers, and there is no guarantee that investors will experience the type of performance reflected above. There is no guarantee that any historical trend illustrated above will be repeated in the future or any way to know in advance when such a trend might begin. Figures may not sum due to rounding. The current market is based on par values of approximately 1,700 capital securities and other deferrable debt instruments denominated in USD, EUR and GBP and issued in the major domestic and Eurobond markets. Generally, denomination size must be a minimum of US$100 million if issued in the U.S. retail market, US$150 million if issued in the U.S. institutional market, EUR 200 million, or GBP 200 million to qualify for inclusion in our universe. Mandatory convertible preferred securities are excluded. Additionally, exchange-traded senior debt securities are included. Weighted-average credit ratings from Standard & Poor’s.
Not all benchmarks are created equal
With most passive ETFs linked to exchange-traded benchmarks, their holdings are primarily in U.S. retail securities. Yet issuers outside the U.S. account for two-thirds of the $1.3 trillion preferred securities market, and 44% of securities are denominated in currencies other than the U.S. dollar.
Our active ETF benchmark, the ICE Large Cap Capital Securities Index – USD Hedged, reflects the broad global universe (Exhibit 3). We believe this benchmark best represents how the preferreds universe has evolved, with the greatest growth coming from the institutional U.S. and non–U.S. dollar markets.
The broad universe provides diversification at the sector, issuer and geographic levels that is not available elsewhere. It also includes securities with resetting coupon structures and foreign currency–denominated issues that can be used to manage credit and interest rate risk. Although the index is global in scope, investors are not exposed to currency risk, to the extent non–U.S. dollar securities are passively hedged to the U.S. dollar.
EXHIBIT 3
We believe we have created a benchmark superior to those employed by passive ETFs
Preferreds benchmark comparison
At December 31, 2024. Source: Intercontinental Exchange, Bloomberg, Cohen & Steers.
Past performance is no guarantee of future results. The information above is for illustrative purposes only and does not reflect performance of any fund or other account managed or serviced by Cohen & Steers. There is no guarantee that any historical trend illustrated above will be repeated in the future or any way to know in advance when such a trend might begin. Credit rating is the average of three nationally recognized statistical rating organizations. Blank rows indicate data is not available. Allocations may not sum to 100% if securities are not internally mapped. An investment cannot be made directly into an index. See endnotes for index definitions and additional disclosures.
Opportunities emerge from return differences across markets
Performance among preferreds can vary significantly by market segment (Exhibit 4). Several factors—including the diverse range of security types, rate structures, credit risks, geographies, and currencies within the preferreds market—drive this dispersion. We believe this return variability offers active managers an opportunity to generate excess returns that passive strategies often miss.
Access to the entire global preferreds universe is crucial, in our opinion. This includes CoCos and global preferred securities (ex-CoCos), which have consistently been among the top-performing categories in the last 10 years.
EXHIBIT 4
Active managers can capitalize across segments of the preferreds market
Annual returns ranked from best to worst (%)
At December 31, 2024. Source: ICE BofA, Cohen & Steers.
Past performance is no guarantee of future results. The information presented above does not reflect the performance of any fund or other account managed or serviced by Cohen & Steers, and there is no guarantee that investors will experience the type of performance reflected above. There is no guarantee that any historical trend illustrated above will be repeated in the future, and there is no way to predict precisely when such a trend will begin. Returns are hedged to the U.S. dollar. See endnotes for index definitions and additional disclosures.
The full market holds the potential for superior long-term returns
The benefits of a broad approach to investing in the preferreds market are evident in Exhibit 5. Over the past decade, the broad market has outperformed the various preferreds segments, particularly the exchange- traded portion.
Active managers harnessing the full market breadth may enhance returns in a variety of ways, such as:
- Diversifying across interest rate regimes by investing in foreign currency–denominated securities
- By conducting in-depth credit analysis
- Identifying pricing inefficiencies
- Leveraging distinct duration and callability features across security structures.
EXHIBIT 5
A broad market approach has historically been the most powerful strategy
Broad market benchmark vs. preferred securities categories (2015–2024)
At December 31, 2024. Source: ICE BofA, Cohen & Steers.
Past performance is no guarantee of future results. The information above is for illustrative purposes only and does not reflect performance of any fund or other account managed or serviced by Cohen & Steers. The full market is represented by the ICE BofA Large Cap Capital Securities Index – USD Hedged. Exchange-traded preferreds are represented by the ICE BofA Core Fixed Rate Preferred Securities Index. USD OTC preferreds are represented by the ICE BofA US Investment Grade Institutional Capital Securities Index. Global preferreds (ex-CoCos) are represented by the ICE BofA Global Hybrid Corporate Index – USD Hedged. CoCos are represented by the ICE BofA Large Cap Contingent Capital Index – USD Hedged. See endnotes for index definitions and additional disclosures.
Conclusion
We believe flaws in benchmark construction and inefficiencies in preferred securities markets make active management a better option than passive investment strategies. Most passive preferred ETFs track the performance of the small (and dwindling) exchange-traded segment of the market, which has generated weak performance in the past decade.
An active approach, unconstrained by the limits of this small market segment and free to pursue securities based on relative value, offers the potential for meaningful excess returns. For instance, based on Morningstar data as of December 31, 2024, over the trailing three, five and ten years, 92%, 86%, and 91% of active preferred securities funds outperformed the typical passive preferred fund, with average annual excess returns of 2.03%, 1.69%, and 1.26%, respectively.(1)
In our view, the ability to invest across the large, global universe is essential, given that performance across security types varies year to year (and by rate environment). By adjusting allocations based on credit quality and spreads, operating in both the retail (exchange-traded) and institutional (OTC markets), and using derivatives for hedging, active managers have powerful tools at their disposal to generate alpha.
(1) Success rate is defined as the percentage of funds within the Morningstar preferred stock category that both survived the sample period in question and delivered returns exceeding the equal-weighted average return of passive funds in the same category over that period. For mutual funds, institutional share class returns were used.
FURTHER READING
Five reasons to consider preferred securities if you own municipal bonds
With many investors feeling the sting of taxes, municipal bonds aren’t the only option for tax-advantaged income. Preferred securities currently offer among the highest after-tax yields in fixed income, regardless of tax bracket.
Tariffs, volatility and the opportunity in preferred securities
In a market shaped by tariffs and volatility, we explore how preferred securities are holding up—and where we see opportunity ahead.
Why preferreds and high yield make a great pair
With many investors turning to riskier bonds for yield, diversification is key. Pairing high-yield bonds with preferreds, which have attractive yields and distinct characteristics, may complement traditional fixed income holdings.
Index definitions and important disclosures
An investor cannot invest directly in an index, and index performance does not reflect the deduction of any fees, expenses or taxes. Index comparisons have limitations, as volatility and other characteristics may differ from a particular investment.
Preferred securities: Exchange-traded: ICE BofA Core Fixed Rate Preferred Securities Index (credit quality: BBB-) tracks the performance of fixed-rate U.S. dollar-denominated preferred securities issued in the U.S. domestic market. OTC: ICE BofA
U.S. I.G. Institutional Capital Securities Index (credit quality: BBB) tracks the performance of USD-denominated investment-grade hybrid capital corporate and preferred securities publicly issued in the U.S. domestic market. CoCos: The Bloomberg Developed Market Contingent Capital Index (credit quality: BB+) includes hybrid capital securities in developed markets with explicit equity conversion or write-down loss-absorption mechanisms that are based on an issuer’s regulatory capital ratio or other explicit solvency-based triggers. Global preferreds (ex-CoCos): ICE BofA Global Hybrid Corporate Index (credit quality: BBB) tracks the performance of investment-grade hybrid corporate debt that is publicly issued in the major domestic and Eurobond markets.
ICE Large Cap Capital Securities Index – USD Hedged captures the largest and most liquid securities in the global preferred securities market, setting a minimum deal size of $750m and limiting the number of high-yield companies to large domestic champions or multinationals. Currency risk is hedged back to USD.
ICE BofA Core Plus Fixed Rate Preferred Securities Index tracks the performance of fixed-rate U.S. dollar-denominated preferred securities issued in the U.S. domestic market. The index includes preference shares (perpetual preferred securities), both DRD-eligible and non-DRD-eligible preferred stock and senior and subordinated debt issued in $25, $50 or $100 par/liquidation increments. Qualifying securities must be rated at least B3 (based on an average of Moody’s, S&P and Fitch) and must have an investment-grade-rated country of risk (based on an average of Moody’s, S&P and Fitch foreign currency long-term sovereign debt ratings).
ICE Exchange-Listed Fixed Rate Financial Preferred Securities Index tracks the performance of exchange-listed fixed-rate U.S. dollar preferred securities and securities that the index provider believes are functionally equivalent to preferred securities issued by U.S. financial companies, such as banking, brokerage, finance, investment and insurance.
ICE Exchange-Listed Preferred & Hybrid Securities Index tracks the performance of exchange-listed U.S. dollar-denominated hybrid debt, preferred stock and convertible preferred stock publicly issued by corporations in the U.S. domestic market. With the exception of convertible securities, both fixed- and floating-rate coupon or dividend securities are included, as well as those with zero, step and rating-dependent payments. Qualifying securities must be exchange-listed and have either the NASDAQ or NYSE as their primary exchange in order to be included in the index.
ICE BofA Diversified Core U.S. Preferred Securities Index tracks the performance of exchange-listed U.S. dollar-denominated preferred stock and convertible preferred stock publicly issued by corporations in the U.S. domestic market.
ICE Variable Rate Preferred & Hybrid Securities Index tracks the performance of floating- and variable-rate investment-grade and below-investment-grade U.S. dollar-denominated preferred stock and hybrid debt publicly issued by corporations in the U.S. domestic market. Qualifying securities must be publicly issued, be U.S. registered or exempt from registration, have at least one day remaining to maturity and at least 18 months to final maturity at time of issuance, be issued in either
$25 or $1000 par increments, and have a floating-rate coupon or dividend. Fixed-to-floating-rate securities are included in the index even while in their fixed-rate period.
Data quoted represents past performance, which is no guarantee of future results. This material is for informational purposes and reflects prevailing conditions and our judgment as of this date, which are subject to change. There is no guarantee that any market forecast set forth in this presentation will be realized. This material represents an assessment of the market environment at a specific point in time and should not be relied upon as investment advice, does not
constitute a recommendation to buy or sell a security or other investment, and is not intended to predict or depict the performance of any investment. This material is not being provided in a fiduciary capacity and is not intended to recommend any investment policy or investment strategy or to take into account the specific objectives or circumstances of any investor. We consider the information in this presentation to be accurate, but we do not represent that it is complete or should be relied upon as the sole source of appropriateness for investment. Please consult with your investment, tax or legal professional regarding your individual circumstances prior to investing.
Risks of investing in preferred securities. An investment in a preferred strategy is subject to investment risk, including the possible loss of the entire principal amount that you invest. The value of these securities, like other investments, may move up or down, sometimes rapidly and unpredictably. Our preferred strategies may invest in below-investment-grade securities and unrated securities judged to be below investment grade by the Advisor. Below-investment-grade securities or equivalent unrated securities generally involve greater volatility of price and risk of loss of income and principal, and they may be more susceptible to real or perceived adverse economic and competitive industry conditions than higher-grade securities. The strategies’ benchmarks do not contain below-investment-grade securities.
Contingent capital securities (CoCos). CoCos are debt or preferred securities with loss absorption characteristics built into the terms of the security, for example, a mandatory conversion into common stock of the issuer under certain circumstances, such as the issuer’s capital ratio falling below a certain level. Since the common stock of the issuer may not pay a dividend, investors in these instruments could experience a reduced income rate, potentially to zero, and conversion would deepen the subordination of the investor, hence worsening the investor’s standing in a bankruptcy. Some CoCos provide for a reduction in the value or principal amount of the security under such circumstances. In addition, most CoCos are considered to be high-yield securities and are therefore subject to the risks of investing in below-investment-grade securities.
Duration risk. Duration is a mathematical calculation of the average life of a fixed income or preferred security that serves as a measure of the security’s price risk to changes in interest rates (or yields). Securities with longer durations tend to be more sensitive to interest rate (or yield) changes than securities with shorter durations. Duration differs from maturity in that it considers potential changes to interest rates, and a security’s coupon payments, yield, price and par value and call features, in addition to the amount of time until the security matures. Various techniques may be used to shorten or lengthen the Fund’s duration. The duration of a security will be expected to change over time with changes in market factors and time to maturity.
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