What is FPE? (Pros, Cons, and Strategies)

In today's unpredictable financial world, diversifying your investment portfolio is more important than ever. One of the asset types investors turn to for diversification and income is Preferred Securities. First Trust Preferred Securities and Income ETF, known as FPE, offers a unique avenue to gain exposure to these assets. Let's delve into what FPE is, its pros and cons, and the strategies to most effectively include it in your investment plan.

What is FPE?

FPE stands for First Trust Preferred Securities and Income ETF. This ETF aims to provide high current income by investing primarily in preferred securities, as well as in corporate bonds, high yield bonds, and convertible securities.

Preferred securities often serve as a middle ground between bonds and common stocks, offering fixed income like bonds while having the potential for appreciation similar to stocks. FPE employs active management to select securities that can provide attractive yields with an eye on risk management.

Key Features of FPE

1. Diversified Portfolio: FPE typically invests in a broad array of preferred securities and other fixed-income assets.

2. Active Management: Unlike ETFs that track an index, FPE is actively managed, allowing professional managers to make decisions about which assets to include or exclude.

3. Income Focus: The primary objective is to generate high current income, making it appealing to income-focused investors.

FPE Composition

FPE holds various types of securities including preferred stocks, convertible bonds, and high yield bonds. These are often issued by large financial institutions, utilities, and real estate investment trusts (REITs). The ETF diversifies its holdings across multiple sectors and issuers to minimize risk while aiming for consistent income.

Pros of FPE

High Income Potential

FPE is particularly favored for its high income generation. Preferred securities usually have higher yields compared to common equity dividends and even many corporate bonds. This high-income feature makes FPE a compelling choice for income-focused investors such as retirees.

Diversification Benefits

By investing in a mix of preferred securities and other fixed-income investments, FPE adds a layer of diversification to your portfolio. This can help reduce risk and volatility, particularly because preferred securities often have lower correlations with both common stocks and traditional bonds.

Professional Management

Active management is one of FPE's key attractions. The experienced management team can make tactical changes to adapt to changing market conditions, aiming to optimize returns and manage risks better than a passive strategy might.

Cons of FPE

Interest Rate Sensitivity

Preferred securities are known to be sensitive to interest rate changes. When interest rates rise, the prices of preferred securities typically fall, which can impact the net asset value (NAV) of FPE. This makes FPE less attractive in a rising interest rate environment.

Credit Risk

FPE’s focus on high yield and preferred securities means it carries higher credit risk compared to U.S. Treasuries or investment-grade bonds. If the issuers of these securities face financial difficulties, it can negatively affect both income and the ETF’s market price.

Complex Structure

Preferred securities often have complex terms and structures, including callable features and dividend deferral clauses. This complexity can present challenges for investors who may not fully understand these intricacies, potentially leading to unexpected income fluctuations.

FPE Investment Strategies

Investing in FPE requires a good understanding of both your income needs and risk tolerance. Here are some practical strategies to consider.

Income-Oriented Strategy

FPE fits well into an income-oriented portfolio. If you're nearing or in retirement and seeking steady income, allocating a portion of your portfolio to FPE can provide attractive monthly distributions. Given its higher credit risk, it should not comprise the entirety of your fixed-income allocation.

Diversification Addition

Adding FPE to a diversified investment portfolio can reduce overall volatility. Its unique composition offers exposure to asset types not widely held in many traditional portfolios. This can smooth out returns, particularly during periods of stock market downturns.

Tactical Allocation Strategy

FPE can also be part of a tactical asset allocation strategy. During periods of stable interest rates or falling rates, increasing exposure to FPE can optimize income and capital appreciation potential. Conversely, in rising interest rate environments, you might reduce holdings or use hedging strategies to mitigate risks.

Conclusion

FPE offers a compelling combination of high income, diversification benefits, and active management—making it a viable option for income-focused and diversification-seeking investors alike. However, its interest rate sensitivity and credit risks add layers of complexity that require careful consideration.

By aligning FPE with your income objectives and risk tolerance, and incorporating it as part of a diversified investment strategy, you can better navigate the financial landscape and achieve your long-term investment goals.