By Carolina Wilson
(Bloomberg) --Exchange-traded funds are supposed to help investors reach corners of the financial markets cheaply through a variety of indexes.
Then there’s VanEck Vectors BDC Income ETF, symbol BIZD.
The fund, which tracks publicly traded business development companies, known as BDCs, is by far the world’s most expensive ETF, with an eye-popping expense ratio of 920 basis points. To understand how high this is, consider that the next closest fund charges 362 basis points, according to data compiled by Bloomberg.
Yet despite the astronomical costs, investors are pouring record sums of cash into the ETF. What gives?
For starters, investors are increasingly attracted to BDCs as a higher yielding alternative to junk-rated debt, and the ETF gives them access to that. BDCs are set up like closed-end investment funds that, like private equity firms, help small and medium-sized companies grow in their initial stages. They’re now taking on a greater share of commercial loans to these businesses, filling a void created by banks that are pulling back from this segment. BIZD buys shares of firms that invest in the debt and equity of these businesses.
“We look at these BDCs as shadow financiers for the middle market,” said Keith Wander, portfolio manager for Roble, Belko & Co. Inc. “We look at this as a surrogate to high-yield, and with this fund you’re getting anywhere from 300 to 400 basis points in yield over high-yield mutual funds.”
Complex Structure
And then there’s the complexity of BIZD’s architecture, with multiple layers that add to its massive expense ratio.
The ETF essentially is structured as a fund of funds in its BDC holdings. As such, the Securities and Exchange Commission requires its expense ratio to include any of the acquired fees from the underlying investment companies it holds, according to Meredith Larson, product manager at VanEck. These fees and expenses are “embedded in the return of the ETF,” but if the added costs are factored out VanEck calculates that investors are actually being charged about 41 basis points for the fund’s management, she said.
Assets for BIZD have taken off this year, increasing by more than 40 percent to $195 million through June 21, according to Bloomberg data. Buyers poured $21 million into the ETF in May, the largest month of inflows since its inception in February 2013, the data show.
The spread of BDC yields relative to more traditional junk bonds has widened this year, nearing 400 basis points compared to the 300 basis-point average, Wander said. To chase that, he replaced the high-yield exposure he was getting through VHDYX, the Vanguard High Dividend Yield Index Fund, with BIZD.
That said, Wander still has some concerns given the potential deregulation of banks and how this could increase competition for BDCs in the space. But the price-to-book for the S&P 500 Banks Industry Group Index has had a nice run up over the past year compared to a flat ratio for BDCs, meaning BDCs are now relatively undervalued. This could help explain the surging demand for BIZD.
VanEck’s Larson doesn’t worry much about bank competition.
“When I speak to analysts their opinion is that as a result of Dodd-Frank a lot of banks had to dismantle a lot of these processes where they would have had these kind of loans,” she said. “They’re not likely to take the time to re-establish that, and BDCs have become well-oiled machines.”
The only other way to get BDC exposure through an exchange-traded product is the ETRACS Wells Fargo Business Development Company Index ETN, ticker BDCS. But exchange-traded notes have counter-party credit risk, which is a turnoff for investors, Larson said.
In fact, David Cowles, director of investment for the San Francisco-based asset manager Mosaic Financial Partners Inc., said he moved out of the ETN and into the fund as soon as the BIZD launched.
“This is a nice way for us to get a little bit of exposure to the venture capital world without running into the hedge fund and private equity kind of investments,” Cowles said. “It has very high historical returns, but also very high volatility.”
To contact the reporter on this story: Carolina Wilson in New York City at [email protected] To contact the editors responsible for this story: Yakob Peterseil at [email protected] Eric J. Weiner
