October 20, 2014
Robert A. Gillam, CFA Chief Investment Officer McKinley Capital Management, LLC
Gregory S. Samorajski, CFA Director of Investments McKinley Capital Management, LLC
McKinley Capital Management, LLC (“McKinley Capital”) has been asked whether it can create an active concentrated portfolio of publicly traded Business Development Corporation1 (“BDC”) equities using the same process it employs to manage its other portfolios, and in particular, its U.S. Equity Income products. This paper contains a discussion of the issues involved in back-testing and managing a BDC product as well as reports simulation results.
McKinley Capital believes that a BDC would need to have a market capitalization of at least $100 million (the minimum for any McKinley Capital mandate) and have an average daily trading volume of at least $1 million in order to be a candidate for inclusion in a BDC portfolio. As of September 30, 2014, the firm identified 32 BDCs that met these minimum criteria. McKinley Capital uses both a quantitative screening process and qualitative overlay to construct and manage investment portfolios. Following the quantitative screening process, only those securities ranked in the top three deciles are considered for further quantitative analysis and possible inclusion in a portfolio. McKinley Capital selects from within these securities on the basis of risk analysis and their qualitative review process ranking.
Given the current investible universe of 32 BDCs, the quantitative screening process would result in a nomination list of approximately 10 companies. Each of these BDCs would then undergo a qualitative review to determine the likelihood that the company would maintain or increase its dividend. Any BDC that failed to pass the qualitative review would be replaced by another BDC on the ranked nomination list.
Back-testing the BDC strategy presents several limitations. First, while the quantitative screening process can easily be reproduced, it is usually not possible to realistically simulate the qualitative side of the process because it is difficult to know what qualitative decisions the firm’s portfolio managers would have made in the past. Therefore, the back-testing process is limited to the quantitative side of McKinley Capital’s process. A second limitation is that prior to 2011, there were never more than 15 eligible BDCs in the investible universe due to liquidity constraints. Finally, an adequate benchmark did not exist until Wells Fargo launched its BDC index at the end of February 2011. For these reasons, the simulation test period will be limited to March 2011 to September 2014 (the “Test Period”).
McKinley Capital constructed an equally-weighted active BDC portfolio comprised of the ten highest quantitatively ranked BDCs that had adequate trading volume and market capitalization (as described above). The portfolio (designated “Back-tested McKinley BDC”) was re-configured each month to account for changing ranks and to maintain equal weighting. As reported in Table 1, the Wells Fargo BDC Index had an annualized return of 6.22% with a standard deviation of 14.39% over the Test Period. During that same period, the Back-tested McKinley BDC portfolio had a simulated annualized return of 8.95% with a standard deviation of 14.15%. Table 2 reports the BDCs in the simulated portfolio as well as some characteristics as of October 20, 2014
For a second comparison, McKinley Capital created an equally weighted portfolio of the 30 BDCs (designated “30 Stock BDC”) with the highest market capitalizations. This portfolio could be considered a proxy for the investment universe, though not all of the stocks in a given month met the minimum trading volume and market capitalization criteria for actual investment. Over the Test Period this portfolio had a simulated annualized return of 2.03% with a standard deviation of 12.69%.
As a final data point, the Market Vectors BDC Income ETF (ticker symbol “BIZD”), with an inception date of February 12, 2013, had an annualized return of 3.24% with a standard deviation of 10.94% from February 28, 2013 to September 30, 2014. Over the same period, the Back-tested McKinley BDC portfolio had a simulated annualized return of 4.50% with a standard deviation of 12.23.
The narrow Test Period presents another limitation of these simulations in that the period does not include a severe down market. During the financial crisis (end of October 2007 until the end of February 2009) the S&P 500 experienced an annualized loss of -41.44%. While McKinley Capital does not know how a McKinley BDC portfolio or how an index of BDCs might have performed during the financial crisis, it is likely that BDCs would have performed poorly. Unfortunately, during that time, there were not a suitable number of liquid BDCs or a comparative benchmark to adequately perform a back-test. During the financial crisis, several BDCs had large losses; Ares Capital had an annualized loss of -61.99%, Prospect Capital had an annualized loss of 28.37%, and Apollo Investment Corp had an annualized loss of -66.02%.
The McKinley Capital investment process, as applied to U.S. Equity Income mandates, features rotation from relatively out-of-favor to relatively in-favor sectors. During the financial crisis, McKinley Capital had very little to no exposure to BDCs. As contemplated, the proposed BDC only portfolio would remain fully invested in BDCs even if McKinley Capital were to sell all or most of its BDC positions in its U.S. Equity Income mandates. McKinley Capital believes that a BDC portfolio would have better results if the manager was permitted to invest up to 50% of the portfolio in other income producing securities during unfavorable BDC markets.
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