Quantifying BDCs' Removal From The Russell Indices

by: Kenneth Deneau


In one week, index-tracking fund managers will be required to sell shares of BDC stocks as the sector is removed from the Russell indices.

BDCs have largely underperformed this year with an average total return of -0.33%.

Short interest in BDC stocks is at its highest since the great recession.

In preparation for the Russell reconstitution investors should position themselves in names with low short interest and fund ownership.

In one week at the close of trading on June 27th all publicly traded Business Development Companies ((NYSEARCA:BDCS)) will be removed from the Russell indices. Fund managers who track a Russell index will be forced to dump their BDC shares on the market. Next week will be an extremely volatile week for the BDC industry, as it historically is for all Russell removals and additions.

Russell's announcement on March 3, 2014 came days after S&P had announced a similar exclusion from its indices. Russel and S&P's reason for excluding BDCs stems from the SEC's Acquired Fund Fees (NYSE:AFF) requirement which forces funds which own BDCs such as Russell ETFs to report a BDC's expenses as if they were their own. Thus, individual investors should not be alarmed by the removal, which was based not on the quality of the investment companies themselves, but solely on fund concerns over the adverse impact of fee reporting standards. While some believed the SEC would amend the fee structure by a May 15th deadline set by Russell, that date quietly passed.

Not surprisingly, BDCs have sold off significantly since Russell first announced their removal in early March. The UBS ETRACS Wells Fargo Business Development Company ETN (BDSC) has a YTD total return of -0.54% and the Market Vectors BDC Income ETF (NYSEARCA:BIZD), has done only slightly better with a total return of -0.34%. Furthermore, even with an average dividend yield of 8.58% if investors owned an equal weighted basket of the 37 BDCs covered in this article, their portfolio's total return would still be off -0.33% from the start of the year. MCG Capital (NASDAQ:MCGC) and Medallion Financial Corp. (TAXI) have been the worst performers, with total returns of -15.29% and -14.94% respectively. On the other end of the spectrum Full Circle Capital (FULL) and Monroe Capital Corp. (NASDAQ:MRCC), two BDCs not listed in the Russell indices, have been spared from the onslaught.

A summary of each BDC's total return, current dividend yield, and mean analyst price target is below.

Company Name Total Return YTD Dividend Yield Mean Price Target
American Capital Ltd. (NASDAQ:ACAS) -4.54% 0.00% 17.57
Apollo Investment Corp. (NASDAQ:AINV) 3.91% 9.63% 9.00
Ares Capital Corp. (NASDAQ:ARCC) 2.04% 8.63% 18.69
Blackrock Kelso Capital Corp. (NASDAQ:BKCC) 0.57% 11.34% 9.25
Capital Southwest Corp. (NASDAQ:CSWC) 1.90% 0.58% -
Capitala Finance Corp. (NASDAQ:CPTA) -2.39% 9.75% 22.19
Fidus Investment Corp. (NASDAQ:FDUS) -7.00% 7.87% 21.00
Fifth Street Finance Corp. (NYSE:FSC) 8.06% 10.57% 10.35
Full Circle Capital Corp. 18.05% 10.33% 8.00
Garrison Capital Inc. (NASDAQ:GARS) 10.97% 9.91% 15.38
Gladstone Capital Corp. (NASDAQ:GLAD) 6.96% 8.33% 9.00
Gladstone Investment Corp. (NASDAQ:GAIN) -1.83% 8.71% 8.00
Golub Capital BDC Inc. (NASDAQ:GBDC) -6.87% 7.17% 18.00
Hercules Technology Growth (NASDAQ:HTGC) 0.37% 8.81% 16.41
Horizon Technology Finance (NASDAQ:HRZN) 4.16% 11.03% 14.54
KCAP Financial Inc. (NASDAQ:KCAP) 2.31% 11.55% 9.38
Main Street Capital Corp. (NYSE:MAIN) 0.18% 6.03% 35.40
MCG Capital Corp. -15.29% 13.19% 3.77
Medallion Financial Corp. -14.94% 6.96% 17.33
Medley Capital Corp. (NYSE:MCC) -3.10% 10.87% 14.98
Monroe Capital Corp. 17.59% 10.05% 14.08
MVC Capital Inc. (NYSE:MVC) -6.84% 4.14% 16.75
New Mountain Finance Corp. (NYSE:NMFC) 0.29% 9.35% 15.31
NGP Capital Resources Co. (NGPC) -14.43% 9.47% 6.50
PennantPark Floating Rate (NASDAQ:PFLT) 5.72% 7.81% 14.90
PennantPark Investment Corp. (NASDAQ:PNNT) 0.43% 10.14% 11.73
Prospect Capital Corp. (NASDAQ:PSEC) -2.69% 12.28% 11.57
Solar Capital Ltd. (NASDAQ:SLRC) -5.11% 7.35% 23.64
Solar Senior Capital Ltd. (NASDAQ:SUNS) -3.29% 8.24% 19.00
Stellus Capital Investment (NYSE:SCM) 0.94% 9.45% 14.90
TCP Capital (NASDAQ:TCPC) 10.11% 8.70% 17.25
THL Credit Inc. (NASDAQ:TCRD) -14.08% 9.86% 14.83
TICC Capital Corp. (NASDAQ:TICC) -2.97% 11.86% 10.56
TPG Specialty Lending Inc. (NYSE:TSLX) - 9.16% 19.13
Triangle Capital Corp. (NYSE:TCAP) -0.26% 8.34% 29.13
TriplePoint Venture Growth BDC (NYSE:TPVG) - 0.00% 17.00
WhiteHorse Finance (NASDAQ:WHF) -0.56% 10.09% 14.88
Mean -0.33% 8.58%  

(Data provided by SNL Financial)

Next week will present a rare opportunity for income oriented investors to scoop up many quality BDC names at bargain prices. After all the dust settles, I believe BDCs are poised to significantly outperform other financials and the S&P as a whole for the remainder of 2014. But which BDCs are expected to experience the largest decline on June 27th? I have examined short interest trends and institutional ownership to gain some insights.

Short Interest

One particularly good measure of market sentiment, especially for high dividend paying stocks like BDCs, is short interest. NASDAQ publicly releases short interest data twice a month. A stock's short interest measured as a percentage of float is calculated by dividing the total number of shares sold short by the total non-restricted shares outstanding. In addition to paying the stock loan fee, the short seller is also responsible for paying the dividend to the firm making the loan. Thus, in a sector where double digit dividend yields are common, short interest is not. Yet as the chart below shows, short interest in BDCs has not been this high since the financial crisis of 2007-08.

(Data provided by NASDAQ)

KCAP Financial currently has the highest short interest among BDCs, but this was the case even before Russell's announcement. Monroe Capital Corp. and Garrison Capital Inc. are two stocks that have experienced notable increases in short interest since mid February. The table below shows the short interest percentage for each BDC at settlement on May 30th, as well as the change in short interest since mid-February.

(Data provided by NASDAQ)

Institutional Ownership

An important measure of each BDC's vulnerability to their removal from the Russell is its institutional ownership. I have laid out the ownership breakdown of each BDC below. I have included which index each BDC is included in (either the Russell 2000 or 1000), the weight of each BDC in the Russell 2000, the total percentage of shares outstanding owned by institutional investors, the percent owned by funds, and the percentage of shares held by index investors such as Russell tracking ETFs or mutual funds (as defined by Thomson Reuters). I then rank each BDC in each ownership metric and average those rankings to determine an overall rank.

(Data provided by SNL Financial, Thomson One, Morningstar, and iShares)

Utilizing these three ownership metrics we see BDCs with the highest percentage of retail ownership include CPTA, WHF, HRZN and MAIN. Whereas BDCs with a heavy institutional ownership include SLRC, MVC, and AINV.

Investors should use the above information as a starting point to assess which BDCs in their portfolio are at most risk of large institutional selling pressure during the Russell reconstitution on June 27th.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.