Why Income Investors Should Look Beyond Index Funds

0:04They're high quality companies that are public, that issue securities that are senior to common, so they get paid first. So they have way less risk than the common of the same company. But yet, they have very good yields, which usually results in very good total return. That was Infrastructure Capital Advisor CEO Jay Hatfield talking about the advantages of preferred stocks. I'm Motley Fool producer Mac Greer. Now, Motley Fool analyst Matt Argersinger and Anthony Chavone recently talked with Hatfield about preferred stocks and about why income investors should look beyond index funds. Fools, we are so delighted to have the opportunity to speak to Jay Hatfield, the CEO and founder of Infrastructure Capital Advisors.

0:53He heads up the firm's research strategy and trading and manages several of the firm's funds, including the Virtus InfraCap U.S. Preferred Stock ETF, the ticker is PFFA, which is a recent recommendation of our ultimate income service here at The Motley Fool. Jay has three decades of experience in the securities and investment industries, including as a portfolio manager at SAC Capital. He also has extensive research and experience in investment banking and played a key role in the formation of NGL Energy Partners, a publicly traded master limited partnership. Jay, thanks for giving The Motley Fool some of your time today.

1:27Thanks, Matt. It's great to be on. All right. Well, before we get to know more about you and Infrastructure Capital Advisors, I was wondering if you could talk a little bit about preferred equities in general, because it's not an asset class that I think the vast majority of our Motley Fool members or readers have experience with. What are, in your mind, some of the big advantages of investing in preferred stocks? And why is an area of the market that investors should probably pay more attention to? Well, there's really two critical advantages of preferred stocks. The first is that they're high quality companies that are public, that issue securities that are senior to common.

2:06So they get paid first. So they have way less risk than the common of the same company, but yet they have very good yields, which usually results in very good total return. So a lot of the yields are 789, like our fund yields around nine right now. And so you get returns, potential returns that are competitive with the market, probably below the market. The market usually does 10, 11. If you're all on tech stocks, you might do 15 or 20. But with way less risks, they're about 40 % as volatiles to market. The default rate has been extremely low, about 0.6 % a year. So you really retain most of that 8%.

2:48So it's a good way to have kind of a baseload, even if you have some speculative stocks where you know you get paid, to get paid every month. And then you can recycle that money either into other stocks or buy more. It's really a great asset class of public companies. And then we only invest in preferred that are listed. So they're easier for us to trade. There's less friction. And we usually do it in a way where we don't have to pay substantial commissions. So a really efficient asset class that I would recommend. You can do it yourself. It's a lot of work. It's hard to build a diversified portfolio.

3:29It should be diversified with fixed income, not necessarily with stocks, but with fixed income. Since they have limited upside, there's no real advantage to concentration. So Jay, kind of on that point, investors have many choices to generate income today. You can look at dividend-paying stocks, investment-grade bonds, high-yield bonds, real estate, plenty of other income-producing securities out there. So what are some of the benefits of preferred equity compared to some of those other income-producing alternatives? Well, the way to think about it is they're very similar to high-yield bonds. They have lower default rates, but similar yields.

4:06So probably in the long run, they'll have better returns. And they do well. So both high-yield bonds and we have a high yield bond fund, BNDS, do well when the stock market's stable to rising and rates are stable to dropping. And so we're in an ideal market for higher risk bonds. For investment grade bonds, so there's a competing fund, BND, that's run by Vanguard, that is investment grade, but they're only yielding four, and they only benefit when the bond, when yields drop, and we think yields are going to drop a little but not a lot. So you can get better total returns when we're coming out of a tightening cycle, because the Fed causes all recessions, the Fed's loosening now.

4:55And so when the Fed's loosening, you want to have higher risk fixed income, not lower risk fixed income. At Amazon, now more than 50 % of the purchases are delivered with less storage, for example in paper bags or even without additional storage. If your neighbor also plays guitar, we deliver your new speaker with sound-tracking in the storage of the manufacturer, based on Amazon-dates of the year 2025 in Great Britain and the EU. Let's talk about the Virtus InfraCap US Preferred Stock ETF. PFFA is the ticker. As I mentioned, we recently recommended the fund in one of our portfolio services here at The Fool.

5:33What is the primary strategy of the PFFA fund? And I'd love to know how it differs from other preferred equity ETFs that exist in the market. One example, of course, being PFF, which is the iShare Preferred and Income Securities ETF. It has a very similar ticker to PFFA. But I will point out that your fund, PFFA, has handily outperformed that fund. In fact, more than doubled its return since inception in 2018. How have you been able to do that? And what are the key differences? Well, I'm sure your listeners and viewers have heard from companies like Vanguard that it can be better to be passive when you're buying mutual funds or ETFs.

6:15But that only holds true for equities and not fixed income. And the reason for that is with equities, they're cap-weighted. And that can be great because when you're cap weighted, you tend to get the best stocks and you get momentum, which is wonderful. But with fixed income, you're doing the opposite of what you should do because these securities are callable at par. So if they're up, then you want to actually sell them, not buy them. And all these large index funds, 70 percent of the market, PFF is the biggest, are, in fact, index funds. So they buy high and sell low. And like I said, that actually can work in the stock market because you get more NVIDIA and get more of the high flying stocks.

7:01But it's a terrible idea. So we manage, we're actively managing. Call risk was really what I was talking about. So they're doing the opposite. But when security goes above par, we start selling it, usually to the index funds, because they don't have any smart beta rules. And when they get inflows, their market makers just go and buy the securities and we can sell it to them. Or if they're rebalancing, which they do every month. We also manage interest rate risk. So we have less interest rate risk when the Fed was tightening, because we correctly forecasted that inflation was going to not just rise, but skyrocket.

7:42And so we anticipated that. And of course, we're constantly managing credit risk. You don't want to be in weak preferred stock credits because they don't do well if there is a bankruptcy. So you want to sell them. And then finally, we can do new issue. So participate in new issues. The index funds cannot. They get listed and typically all the index funds and bid up those securities. And we start selling to them. because we stole their good companies and they're liquid. So we start selling to them at higher prices. So we're able to get significant gains without taking a significant risk, whereas the index funds cannot do that.

8:25That's interesting. I can imagine a lot of investors, retail investors in particular, don't know that. But what you're saying is it's actually in the bond and fixed income world and in the preferred equity world, it sounds like active management is what you want to be following. It's really critical. Well, like I said, you can go look. There's listings and Barron's and other sources, maybe on Motley Fool, for preferred stocks. But you also have to do a lot of analytics because you can say, oh, my gosh, this is great. There's a Ford preferred trading at a nine yield, but you don't realize it's trading at 26, callable at 25, and it's going to get called any time or it might have already been called.

9:05So you do have to do a lot of work. You don't want to be in low quality credits. got to manage the interest rate risk. So you can do it yourself, but it's simpler. Like I don't do it in either my personal account. I have levered PFFA in my personal account. IRA is 60%, 65 % PFFA. And the reason for that is that I don't want 200 preferred stocks in my IRA. It's just it would be an unbelievable mess. it's not worth it for me to go in and manage each security and say oh well i have a thousand shares of this preferred and is trading at 2550 and i'll sell it like i don't have time to do that i have to of course manage pffa but even for anybody that's just like it's not really worth their time like it's if you have a diversified portfolio prefers why bother but for us we have hundreds of thousands of shares, and we have institutional trading techniques to take advantage of that.

10:06So there's economies of scale for having an ETF managed by people like us where it's absolutely worth their time to worry about whether you sell it at$25.50 or$25.25 or$25.75. So a unique situation where, like I said, perfectly reasonable to go buy your own stocks, do your own work, but way simpler or buy an ETF that's just an index fund. But harder to do it yourself on preferreds and bonds. Bonds aren't usually listed and can create a big distraction in your portfolio when you should be worrying about selling Tesla at$4.75. You're staring at all these preferreds moving around by five cents every day.

10:52I guess we'll wrap up here with two more sort of questions on the economy. So I'm curious if you have any thoughts on the massive CapEx boom that we are currently seeing and the potential implications for real assets. Like when I look at big tech and the Mag7 companies, these have historically been asset-like businesses that's almost exclusively invested in the digital world. But now those same companies are investing hundreds of billions into the physical world. So I'm curious if you have any thoughts on how this CapEx boom kind of impacts physical assets like real estate, energy and some other old economy stocks.

11:28Well, I guess my reaction would be, thank God, because, you know, the normal cycle. So the Fed raises rates. Of course, the 10 year goes up as well, usually about 100 over whatever the Fed raises it to. And then housing and construction crater, which they have. And you can get that data on our website. I mean, that's just public data, but we summarize it for you in a slide on our website. So the old economy, so construction and housing are in recession. So over the last year, those investment categories have dropped. And by the way, investment drops create all recessions. But intellectual property, a.k.a.

12:11AI investment and equipment, which a lot of that's semiconductors and also could be data centers and could be power, is actually pretty strong. And so those two kind of cancel each other out. And we have modest growth. We think next year will be really good. But so we agree with you 100 percent because, you know, we are around for the Internet boom. And it really, it completely busted. Investment went down, but it was really, as you're pointing out, just some laptops and a bunch of tech engineers. So it didn't really have that big an impact on the economy. We had a very shallow recession, 0.6%, because it didn't impact data centers and chips and all these other categories.

12:56So we might get a cycle in the future. It's not housing driven, but it's solely driven by a cycle in tech because it is kind of impacting the whole economy, not just software and laptops and tech engineers. Have you ever gazed in wonder at the Great Pyramid? Have you marveled at the golden face of Tutankhamun or admired the delicate features of Queen Nefertiti? If you have, you'll probably like the History of Egypt podcast. Every week, we explore tales of this ancient culture. The History of Egypt is available wherever you get your podcasting fix. Come, let me introduce you to the world of ancient Egypt.

13:49Just to follow up, in a recent interview, you briefly mentioned something about what you referred to as the Hatfield Rule as it relates to home building and the economy. Can you just briefly explain to us what is the Hatfield Rule? Because I think it's essentially a concept, especially considering the current state of the housing market. Right. So that also is meant to be slightly amusing because there's a thing called the Psalm Rule, which is when employment rises quickly over six months. So we thought it's a free country, so we'll come up with our own rule. But if you really look historically, as I mentioned, And all recessions don't come from the consumer.

14:24So everybody's wrong about that. Everybody on television is wringing their hands about the consumer. Actually, it comes from drop in investment. And 12 out of 13 post-World War II recessions were caused by housing declines. And if you draw a line, we have a chart that shows this. You can see that once we go below 1.1 million, we do have a recession. And that was obviously the key driver in 2008, but it's been the key driver except every recession, except that 2001 recession. Global rates are dropping, so housing hung in pretty well, and all the drop was in the tech categories, but it was an extremely mild recession.

15:07So it is critical. So if you buy into our methodology of focusing on my supply, which is the Fed and oil, then the way, though, you need to also assess what's happening is look at the housing market. And that's why we had to call all year long that the Fed would cut three times because we thought that the housing market was going to slow and then the labor market was slow. We looked like we were wrong for a while because the BLS takes a long time to figure out when the employment market's declining. So if you just have those three components, the Fed is the most important, and then housing, we're really just two.

15:47You can predict the inflation and economy nearly perfectly. You just have to make sure, of course, oil's not going to infinity. But that's not going to reoccur unless we have wage and price controls. Everybody kind of forgets oil was capped at 10 bucks a barrel. World price was 40. Our production went to near zero and that made the oil crisis way worse. So not likely to occur in the future on the oil side. So what's the Fed and housing? You don't need to listen to me pontificate. You could do it yourself and make your own forecasts. And we've been doing that since the pandemic. And like I said, historically, it's been very accurate and strongly.

16:29if anybody cares about macro, which you should if you're an investor, watch the money supply. Easier use the base. It comes out every Thursday or look on our website. We keep track of it. I've been keeping track of it for 45 short years, ever since I studied monetarism in college, and it's kept me out of trouble. If you followed that, you would have been able to predict every recession, really. Well, Jay, thanks again for giving The Motley Fool some of your time today, I know this is going to be really helpful, not only to our members that own PFFA or are already interested in preferred equity, but we have a large member base who would probably never explore the asset class.

17:08And so I think they're going to find this super, super interesting. Thank you so much. Great. Thanks, Matt and Anthony. Great questions.

17:18As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against. So don't buy or sell stocks based solely on what you hear. All personal finance content follows Motley Fool editorial standards and is not approved by advertisers. Advertisements are sponsored content and provided for informational purposes only. To see our full advertising disclosure, please check out our show notes. For the Motley Fool Money team, I'm Matt Greer. Thanks for listening, and we will see you tomorrow.