Vanguard's Index Changes Could Hamper BDCs

Vanguard, the third-largest U.S. ETF issuer, made waves on Tuesday by announcing index changes for 22 of its funds. News that the Vanguard MSCI Emerging Markets ETF (NYSE:VWO) will drop the MSCI Emerging Markets Index in favor of the equivalent index sponsored by FTSE Group garnered the most attention.

The change, which will see VWO eliminate its exposure to South Korean equities, is the largest international index switch on record, according to FTSE Group. Fortunately for investors in South Korean equities and ETFs such as the iShares MSCI South Korea Index Fund (NYSE:EWY), the impact is expected to be minimal and not create significant downside pressure.

Other stocks may not be so fortunate. Business development companies, or BDCs, could be adversely affected by Vanguard's decision to change indexes on three of its small-cap ETFs. Those funds the Vanguard Small-Cap ETF (NYSE:VB), the Vanguard Small-Cap Growth Index Fund (NYSE:VBK) and the Vanguard Small-Cap Value ETF (NYSE:VBR) will drop MSCI indexes in favor of indexes constructed by Chicago's Center for Research in Security Prices (CRSP).

The CRSP indexes do not make room for BDCs, a group of equities prized for high yields and robust payouts. While Vanguard has promised its departure from stocks not featured in the CRSP indexes will be gradual and orderly, there is no getting around the fact that some BDCs could see some selling pressure.

"BDCs in Vanguard's small-cap funds could be affected because Vanguard is the largest holder of these stocks in some cases," Morningstar Research Director Paul Justice said in an interview with Benzinga from the Morningstar ETF Conference in Chicago.

Justice's view was reiterated Morninstar ETF Analyst Michael Rawson in a presentation to media members today.

TICC Capital (NASDAQ:TICC), a BDC with a yield north of 11 percent, is held by VB, VBR and the mutual fund equivalents. Vanguard owned almost 1.73 million shares of TICC at the end of the second quarter, according to Yahoo Finance data.

VB and VBR also hold Prospect Capital (NASDAQ:PSEC), which yields 10.6 percent. Overall, Vanguard ETFs and mutual funds owned over 6.3 million shares of Prospect Capital as of the end of the second quarter.

Those are just two examples and the stocks do not appear to be reacting to news of the Vanguard index changes -- at least not yet.

Investors may want to monitor the UBS ETRACS Wells Fargo Business Development Company ETN (NYSE:BDCS). BDCS has average daily volume of just 12,000 shares, but an annual index yield of almost 10 percent. However, the ultra-high yield is arguably overshadowed by ultra-high fees of 0.85 percent that are accrued on a daily basis, according to the fund's web site.

BDCS has a leveraged cousin in the form of the UBS ETRACS 2xLeveraged Long Wells Fargo Business Development Company ETN (NYSE:BDCL), which has a current annual leveraged yield of almost 19 percent. Like BDCS, BDCL charges 0.85 percent, also accrued on a daily basis.

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