Standard & Poor's manages the stock market's most important benchmark index, the S&P 500. And as the index sponsor, it decides which companies may join its indexes, and which are excluded.
On Monday, a press release explained that it will eliminate business development companies from its S&P U.S. Indices.
The news led to a largely red day for most BDCs. One of the most affected was Prospect Capital (NASDAQ:PSEC), which traded down 2.7%, a rather large move for what is essentially a closed-end fund. Prospect Capital will be removed from one of S&P's larger indexes, the S&P Small Cap 600.
BDCs that are on the edge of qualifying to be in the larger S&P 500 index, like Ares Capital (NASDAQ:ARCC) and American Captial (NASDAQ: ACAS) won't have the opportunity to join at all.
Why S&P is dumping BDCs
Closed-end funds and exchange-traded funds are largely excluded from stock market indexes. The thinking is these funds simply overlap, meaning that if they were included, it would distort the balance of stocks in an index.
However, BDCs were previously allowed because they invest in non-public companies, giving investors unique exposure.
In the press release, Standard & Poor's explains its rationale for excluding BDCs from its American indexes:
After consulting with clients concerned with certain reporting requirements, expenses, and investment restrictions relating to business development companies (BDCs), S&P Dow Jones has decided to remove all identified BDCs from its U.S. Indices.
S&P's marketing problem
My skeptical eye immediately fixates on "expenses" as the reason BDCs were excluded. I've noted before that BDCs are expensive, with externally managed BDCs costing investors as much as 4%-5% per year in assets. That's no small expense.
For Standard & Poor's, BDCs present a bit of a marketing problem. Today, indexes are largely built for use by ETFs. When ETFs report expenses, they have to combine all expenses at the ETF-level with expenses in the holdings of the ETF.
Take the BDC Income ETF (NYSEMKT:BIZD) as an example. The fund reports a net expense ratio of 8.33% per year, making it look like the most expensive ETF on the planet. In all reality, Van Eck, the manager behind the fund, takes a fee of only 0.40% per year. The remaining expenses come from expenses at the BDC level.
To draw a comparison, it's as if an ETF of bank stocks had to include overhead costs of each bank in its total expense line. Bank ETFs don't have to do that, but BDC ETFs and indexes that include BDCs do because they have a different corporate structure.
Why it doesn't matter
Sure, Prospect Capital will likely see a few days of volatility as indexes readjust. Maybe other BDC leaders, like Ares Capital or American Capital, won't ever make it into the S&P 500. But it's really not a big deal at all.
The index world is rapidly evolving. The companies that win with indexes are those that have the lowest expenses. Cutting out BDCs allows them to knock a few basis points off the cost of an index, and avoid tax issues from pass-through structures common with BDCs, which may win the sponsors new licensing deals.
The bottom line is business development companies bit the bullet for the marketing teams. If there were ever a reason to dump your BDC investments, this certainly isn't it.