There are many key themes to pick from, from continued NAV growth in the sector, to very high levels of prepayments, to the refinancing wave and lower debt costs and more – all of which we have highlighted on the service and will discuss in more detail in future updates. In this weekly we check in on the track record of funds in the BDC space.
There is a mantra in the sector that investors should steer clear of passive funds that allocate to BDCs because they either tilt to lower-quality BDCs and/or have poor historic returns.
The reality, as is often the case, is more complicated. Let’s take a look at the performance of three funds that allocate to BDCs:
- VanEck BDC Income ETF (BIZD)
- ETRACS MVIS BDC Index ETN (BDCZ)
- First Trust Specialty Finance and Financial Opportunities CEF (FGB)
The chart below presents the 5-year total returns of these three funds (FGB returns are shown from an NAV perspective to control for the discount / premium CEF behavior) relative to the broader BDC sector. The blue line shows the average 5-year annualized total return of the BDC sector (excluding the funds) and the green line shows the median return. Not all BDCs are presented below but enough of them to be useful, in our view.
Source: Systematic Income
The chart shows a couple of things. First, it is clear that the three funds have indeed missed out on some of the enormous returns in the highest-performing BDCs.
Secondly, the 5-year ETF/ETN returns are about 2-3% below the average of the BDC sector though pretty much in line with the median performance and with absolute performance of 8-10% which isn’t too bad. Their median performance shows that they have underperformed and outperformed roughly the same number of BDCs. This suggests that they are not the vast sector underperformers they are often assumed to be.
Thirdly, what really stands out is the terrible performance of the CEF FGB which certainly seems odd on a couple of fronts – the sheer scale of its underperformance, the fact that its leverage should have allowed it to outperform given the strong trend in the BDC space over the last 5 years and the fact that it is actively managed which, presumably, should have allowed it to sidestep some of the persistent underpeformers in the sector.
What is going on here?
Readers who are familiar with our CEF analysis may already know that we have a bias against owning equities or other relatively volatile assets in CEF format for a few reasons. First, CEFs aren’t great vehicles for these more volatile assets (e.g. CLO Equity, MLPs, stocks etc.) because of their leverage constrains.
BDCs tend to have much higher volatility than the usual equity indices. For eample, the Q1-20 drawdown was around 50% for BDCs while the S&P 500 was down only around 33%. This level of drawdowns will drive deleveraging in leveraged CEFs which is why you tend to see that MLP CEFs underperform MLP ETFs and FGB hugely underperform the broader sector. The fund’s shareholder report clearly shows how the fund deleveraged in 2020, locking in economic losses for investors. This is not the only reason for its underperformance but it is an important one.
The other reason we tend to avoid equity-focused CEFs is that, for the majority of equity CEFs, active management, doesn’t really seem to work, even outside of the deleveraging issue (most equity CEFs are not leveraged). We have shown several times that most equity CEFs tend to underperform the broad (or the relevant sector) equity indices. The reality is that the average CEF is around $500m of AUM which is pretty small in the broader fund management landscape and even though some managers can be responsible for multiple funds, it’s not at all obvious why the most talented managers should choose to play in what is a fairly small pond rather than run much more money on the institutional or hedge-fund side.
If we put the performance issue aside for the moment, some investors may be attracted to a CEF like FGB because it trades at a discount – about 6.5% currently – with the view that they can own a bunch of BDCs (that they would otherwise hold anyway) at a discount to their market price. In other words, you can pay 100% for something or 94% for the same thing – why wouldn’t you take the 6% discount offered by the CEF since it seems like a free lunch.
It is important to stress, however, that there is no free lunch here. FGB charges investors 1% in management fees (and a bit more in fund expenses) so it should trade at a discount that reflects its fee. As it happens with BDC yields of around 8%, the fund should trade at least at a 12.5% discount (in order to compensate for 1/8th of its yield going to the manager rather than the investors). However, because FGB only trades at a 6.5% discount it is actually expensive to fair-value. The fund’s leverage does allow it to provide additional yield, however that comes at the cost of deleveraging which is, on net, a negative as we discussed earlier.
This fair-value calculation also ignores any alpha which is obviously negative in FGB so its discount should probably be on the order of 30% or so in reality. We have discussed this “deleveraging tax” before – an issue that tends to be swept under the rug by CEF cheerleaders but it’s a real thing and needs to be looked at seriously when evaluating CEFs trading at either elevated leverage or holding highly volatile assets. In the case of FGB this tax appears to be on the order of 8-10% per year over the past 5-10 years. Stated in another way, this tax is basically 100% of the income that the fund generates. This doesn’t mean the fund will continue to perform as poorly in the future – it could do OK over the next few years if market volatility remains subdued. However, it is not a fund that makes sense to hold “through the cycle” in our view.