Summary There are two issues with the ETF, one is a high expense ratio and the other is sector concentration. The geography exposure is not a problem for me, but I wouldn’t mind seeing a little more diversification. The fund offers negative correlation with at least one treasury ETF while delivering a beta of around .22. Many investors build their portfolio without any meaningful positions in preferred stock. The iShares U.S. Preferred Stock ETF (NYSEARCA: PFF ) is one quick solution to that problem. Expense Ratio The expense ratio on the ETF is .47%. I’d really prefer to see a lower expense ratio with long term holdings since the nature of preferred stock suggests positions would not need to be changed frequently. When I pulled up the turnover ratio for the portfolio, it was coming up as 13%. That is higher than I would have expected but not high enough that I would expect the high expense ratio to be necessary. This may simply be a case of an ETF in a niche market having a long track record (established in 2007) and high volume (over 3 million shares per day) being a position where it can demand a higher expense ratio. Largest Holdings The largest holdings of the ETF show a heavy concentration towards the financial sectors. It isn’t just the top 10 though, as you’ll see in the next section. The sector exposure for PFF is heavily concentrated on banks and “Diversified Financials.” Sector The sector exposure is extremely concentrated and that would be an area of concern for me. Since my goals in using preferred shares within a portfolio would be to diversify the risk factors for the portfolio, I would prefer to only need one ETF of preferred stock and to have that ETF bring in a substantially lower level of concentration. I don’t know what would cause the sector to tumble, but very heavy sector exposure leaves investors hoping no black swans appear. This is a risk I would prefer to avoid if possible. Since black swan events by their very nature are unpredictable, the most effective defense is simply to include substantial diversification. Geography The map below shows the geographic distribution of the holdings. I don’t see any problems here. It is interesting that the U.K. was showing up as more than 12% of the portfolio, but diversification is exactly what I was wanting. I’d be interested in seeing even more diversification here, but doubt it will happen. That could make PFF an interesting fit with an international bond portfolio. Building the Portfolio This hypothetical portfolio has a slightly aggressive allocation for the middle aged investor. Only 30% of the total portfolio value is placed in bonds and a third of that bond allocation is given to emerging market bonds. However, another 10% of the portfolio is given to preferred shares and 10% is given to a minimum volatility fund that has proven to be fairly stable. Within the bond portfolio, the portion of bonds that are not from emerging markets are high quality medium term treasury securities that show a negative correlation to most equity assets. The result is a portfolio that is substantially less volatile than what most investors would build for themselves. For a younger investor with a high risk tolerance this may be significantly more conservative than they would need. The portfolio assumes frequent rebalancing which would be a problem for short term trading outside of tax advantaged accounts unless the investor was going to rebalance by adding to their positions on a regular basis and allocating the majority of the capital towards whichever portions of the portfolio had been underperforming recently. (click to enlarge) A quick rundown of the portfolio The two bond funds in the portfolio are the iShares J.P. Morgan USD Emerging Markets Bond ETF (NYSEARCA: EMB ) for higher yielding debt from emerging markets and the iShares 7-10 Year Treasury Bond ETF (NYSEARCA: IEF ) for medium term treasury debt. IEF should be useful for the highly negative correlation it provides relative to the equity positions. EMB on the other hand is attempting to produce more current income with less duration risk by taking on some risk from investing in emerging markets. The position in the iShares MSCI USA Minimum Volatility ETF (NYSEARCA: USMV ) offers investors substantially lower volatility with a beta of only .7 which makes the fund an excellent fit for many investors. It won’t climb as fast as the rest of the market, but it also does better at resisting drawdowns. It may not be “exciting,” but there are plenty of other areas to find excitement in life. Wondering if your retirement account is going to implode should not be a source of excitement. The position in the PowerShares Buyback Achievers Portfolio ETF (NYSEARCA: PKW ) makes the portfolio overweight on companies that are performing buybacks. The strategy has produced surprisingly solid returns over the sample period. I wouldn’t normally consider this as a necessary exposure for investors, but it seemed like an interesting one to include and with a very high correlation to SPY and similar levels of volatility it has little impact on the numbers for the rest of the portfolio. The core of the portfolio comes from simple exposure to the S&P 500 via the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ), though I would suggest that investors creating a new portfolio and not tied into an ETF for that large domestic position should consider the alternative by Vanguard, the Vanguard S&P 500 ETF, (NYSEARCA: VOO ) which offers similar holdings and a lower expense ratio. I have yet to see any good argument for not using or another very similar fund as the core of a portfolio. In this piece I’m using SPY because some investors with a very long history of selling SPY may not want to trigger the capital gains tax on selling the position and thus choose to continue holding SPY rather than the alternatives with lower expense ratios. Risk Contribution The risk contribution category demonstrates the amount of the portfolio’s volatility that can be attributed to that position. To make it easier to analyze how risky each holding would be in the context of the portfolio, I have most of these holdings weighted at a simple 10%. Because of IEF’s heavy negative correlation, it receives a weighting of 20%. Since SPY is used as the core of the portfolio, it merits a weighting of 40%. Correlation The chart below shows the correlation of each ETF with each other ETF in the portfolio and with the S&P 500 . Blue boxes indicate positive correlations and tan box indicate negative correlations. Generally speaking lower levels of correlation are highly desirable and high levels of correlation substantially reduce the benefits from diversification. Conclusion PFF has a positive correlation with each of the hypothetical holdings except for the treasury ETF which is interesting. Since PFF should have more duration exposure than IEF, but also more credit risk, there is some fairly solid diversification benefits here. The beta of only .22% is also excellent for indicating that PFF will fit very well within a portfolio. While EMB (emerging market bonds) also have a very low beta, PFF is has done it without having a positive correlation with treasury ETFs. That makes it a great fit for the more conservative investor that is holding more treasuries in the portfolio and less equity. The distribution yield on PFF is over 6%, so this is an option for solid income while maintaining a favorable risk profile. Ideally an investor would be able to combine this with a position in an emerging bond fund like EMB to avoid concentration of risk and then toss some higher dividend yielding ETFs in at the core position and offset the equity risk with some long term treasury exposure. In short, I’m not thrilled with the expense ratio but the fund fits very well within a portfolio. I would love to see more preferred share ETFs coming out to drive up competition and drive down expense ratios. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.