The VanEck BDC Income ETF (NYSEARCA:BIZD) is an exchange traded fund offering investors exposure to a large portion of the BDC Universe. The fund has tracked broad sector exposure but has underperformed top holdings for several reasons.
BIZD is a market cap weighted ETF that invests in the largest and most liquid business development companies in the United States. Business development companies are specialty finance firms which provide debt and equity financing to companies which are otherwise unable to access the capital markets. BDCs target firms in the middle market economy, which can often be volatile. These smaller firms generally seek out BDCs as a main source of financing either for growth or recapitalization. To account for these risks, BDCs generally lend capital with high interest rates, translating to high yielding dividends for shareholders. BIZD offers exposure to a variety of publicly traded BDCs and carries a high current yield of 7.76%. It's worth noting the current yield offers a sizeable premium to other income-producing assets as well as inflation.
With the rate of inflation currently hovering consistently above 5.00%, it is worth noting that BIZD is the only option above that offers a positive spread based on current share prices. The high yield stems from taxation rules applied to BDCs. Business development companies have similar tax requirements to REITs, needing to distribute 90% of taxable income in the form of dividends to avoid corporate-level taxes.
Investors should expect to receive a premium yield given the risks of middle-market lending. However, unexpectedly, the secured loans inside of BDC portfolios have performed well during periods of stress. Default and recovery rates have outperformed those of high yield counterparts. Additionally, outperformance of the sector through the COVID-19 pandemic was surprising, but welcome.
Source: Guggenheim Investments
Source: Guggenheim Investments
The result is an asset class often overlooked by investors due to surface-level risks. However, long-term performance and the yield opportunity could make income-oriented investors reconsider. BIZD offers investors a simple option to access a broad range of BDCs.
BIZD is managed by VanEck, a well-established manager of a broad ETF lineup. The fund is relatively small with $516 million in assets currently under management. The fund takes an index approach, offering exposure to the primary US BDC index. With a strict allocation to BDCs only, the fund has twenty-five positions which are concentrated to the domestic financial sector. Using a market cap weighted approach, the fund offers more exposure to the largest, established players in the sector. The top ten include highly recognizable names in the space and account for over 70% of the total portfolio.
Source: Fact Sheet
The fund is simple and straightforward in its construction. It is one of the few funds which offer a BDC-limited portfolio. To maintain the fund, VanEck charges a reasonable management fee of 0.40%.
The BDC sector has performed well over long time periods, experiencing high volatility under periods of stress. BIZD has provided a substantial portion of total return through distributed dividends due to strict tax requirements. As a result, share price has been expectedly poor but compensated in terms of total return.
The fund has additionally outperformed other financial counterparts. The high distributions have fueled performance leading BIZD to perform in line with the Financial Select Sector SPDR ETF (XLF) and the SPDR S&P Regional Banking ETF (KRE). That said, we would prefer to see outperformance when accounting for the added risks associated with BDCs as opposed to traditional banks.
Having highlighted the distribution as an important component of the fund, how has the income performed? BIZD distributes income on a quarterly basis with a TTM yield of 7.76%. Over time, the distribution has not grown significantly, but has remained rather consistent. However, 2020 was the lowest distribution in the fund's history with a 6.77% decrease as compared to 2019. Given the rampant shutdowns and economic stress, the distribution could have fared far worse.
With strong performance driven largely by current income, BIZD is an option for income investors willing to accept higher risks in exchange for superior income potential. With a widely diversified portfolio, BIZD can add meaningful yield; however, we will reiterate that the risks certainly exist. For investors looking to step into BDCs, BIZD offers a simple solution with acceptable concentration risk. That said, the indexed format limits the fund's overall potential for several reasons.
BIZD's market capitalization weighted index approach provides sector wide exposure to BDCs. Investors have turned to index ETFs such as the SPDR S&P 500 Trust ETF (SPY) due to their market performance. We have no qualms given that most active managers have not been able to earn their value through outperformance. The active and passive management debate has raged for decades. Investors are often enticed by the promise of outperforming management; however, expenses and other factors often cause funds to fall short. Having said that, business development companies differ from the broader equity market. The companies operate relatively transparent portfolios offering superior insight to investors looking to form a thesis around specific firms.
BIZD's index approach is certainly a positive for investors looking to mitigate risk by widening their sector exposure. That said, a portfolio spread across the entire asset class eliminates the opportunity to outperform. As a result, BIZD's performance has been limited, especially as compared to some of the fund's largest holdings. Understanding potential reasons why is essential in understanding the sector at large. Business development companies differ from many other publicly traded investments in the narrow nature of their strategy. By providing debt and equity financing, BDCs have a narrow business model which should not see substantial change going forward. Compare this concept to many popular public investments which rely on continued innovation and branding in order to maintain a competitive advantage in their sector. Staying one step ahead of the future can be exhausting and execution risk certainly exists in the long term, especially for leaders of the pack.
On the other hand, Business development companies have different success drivers which can be more predictable. To understand, we must look at how BDCs operate. BDCs loan capital to portfolio companies with the expectation of earning a spread over their internal weighted average cost of capital or WACC. Firms' ability to access new deployable capital at advantageous rates is directly tied to their current balance sheet health and creditworthiness. This means larger, well-established players will have superior capital markets access. Lower cost of debt will afford these larger players two distinct advantages. First, capital can be deployed to safer companies with a lower interest rate, while still maintaining the BDC's investment spread. Second, capital can be deployed in comparable opportunities with more attractive spreads than smaller companies. In other words, all else being equal, larger firms receive better internal performance from the same opportunities than smaller companies.
Going further, well-established, blue chip players have excellent relationships with current clients. While the middle market certainly sounds risky, the segment can include well-established companies that are household names. Established firms generally have ongoing financing relationships with BDCs which can be difficult to disrupt. As expected, many of the best clients in the space work with the best lenders. These competitive advantages benefit the stronger players with better opportunities that carry more attractive IRRs.
Investors looking to access the BDC sector have a wide variety of options. While BIZD offers wide sector exposure in an ETF wrapper, investors may also invest in the ETF's holdings directly. Given the competitive advantages offered by some firms, we believe further due diligence can benefit investors. Two worthy contenders in the segment are found high in BIZD's portfolio holdings.
Ares Capital Corporation is the largest business development company by market cap at $9.48 billion. Furthermore, Ares is possibly the most experienced manager in the segment with an impressive portfolio of solid clients. ARCC has operated since its inception in 2001 generating impressive shareholder returns along the way. ARCC offers a current yield of 7.71% and has a history of special dividends to supplement the current distribution. It is worth noting, the firm cut the distribution in 2009, but maintained through 2020. ARCC has an investment-grade credit rating and strong balance sheet, reinforcing the fund's ability to access deployable capital. The firm's limited equity exposure has provided share price appreciation in the long term as well. ARCC is externally managed, which we generally dislike on account of shareholder conflicts of interest and high management fees. That said, the fund's long-term performance and position as a flagship investment for Ares provide a layer of confidence.
Another viable alternative is also found in the top ten holdings. Main Street Capital Corporation is a favorite in the Seeking Alpha community. The firm is well established having operated through several market cycles including the Great Financial Crisis and COVID-19. The firm distributes steady monthly income to shareholders which is supplemented by capital gains distributions throughout the year. Having consistently paid regular dividends, including through the pandemic, it's easy to see why MAIN has become a fan favorite. The firm's $3 billion market cap and best in class portfolio have positioned MAIN to succeed in the future. Despite a mediocre current yield (as compared to other BDCs) of 5.76%, MAIN's larger equity investments have resulted in impressive NAV and share price growth. Our positivity around the firm is reinforced by an internal management structure which limits costs and directly aligns the interest of management and shareholders. A premium firm requires a premium price. MAIN's valuation is notoriously stretched, and the firm currently trades at a NAV multiple of 1.87x.
The size of ARCC and MAIN has positioned the firms as some of BIZD's largest holdings. Keep in mind, the firms each have a market capitalization greater than the ETF itself. Their positions in the BDC ecosystem have provided historically strong access to capital and superior clients, resulting in outperformance over various time periods. The performance differential is substantial as ARCC and MAIN have nearly doubled BIZD's total return since 2013. Further, in 2020, both ARCC and MAIN were able to maintain their regular distributions while BIZD's dividend dropped. As the landscape becomes more competitive and rising rates place an emphasis on the underlying quality of portfolio companies, BDC quality becomes paramount. Superior businesses could have a better chance to mitigate risk and volatility, especially during periods of stress.
BIZD is a quality ETF administered by an experienced firm. The fund's positive performance and relatively limited volatility are indicative of a successful strategy. That said, the indexed approach limits the ability to capture outperformance in a small sector. Competitive advantages can often be identified by investors who are willing to dive into transparent portfolios and form an independent thesis. While indexing has been effective for broad equity exposure, BIZD has historically suffered from tepid performance.
Aggressive investors looking to generate income may find attractive yield in BDCs. As we mentioned, the companies are generally susceptible to economic downturns as middle-market firms can lack the creditworthiness to survive prolonged hardship. However, history has proved that there is a layer of resilience in the "main street" economy of the middle market. As the United States economy continues to grow, the middle market should continue to drive much of the performance. Whether investors elect to pursue the index or individual constituents, the sector has produced strong historical performance.
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Disclosure: I/we have a beneficial long position in the shares of MAIN either through stock ownership, options, or other derivatives. 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: This article is not to be considered investment advice. Research provided in this article is supportive of your own thorough and complete due diligence. Please consult your investment advisor on opportunities presented herein.