XLV - HQH: Higher Risk Healthcare CEF

2023-03-05 07:56:14 ET

Summary

• The HQH fund aims to provide high total returns through investments in the healthcare industry. HQH has a high allocation to risky biotech stocks and private investments.
• The fund pays a 2% of NAV quarterly distribution. However, HQH has under-earned relative to its distribution in the past 5 years.
• Comparing HQH to its sibling Tekla funds, I would recommend income-oriented investors choose the THQ, as THQ has a more consistent returns profile and a more sustainable distribution.

The Tekla Healthcare Investors ( HQH ) is a closed-end fund that aims to generate high total returns through investments in the healthcare industry. The HQH fund has a high allocation to risky biotech stocks and private investments.

Although the fund's 2% quarterly distribution does not appear too high, investors should note that the fund has not 'earned' this distribution in the past 5 years. Comparing HQH to its sibling Tekla funds, I prefer the Tekla Healthcare Opportunities Fund ( THQ ), as THQ has steadier long-term performance and a more sustainable distribution.

Fund Overview

Tekla Healthcare Investors is a closed-end fund ("CEF") that invests exclusively in the healthcare industry, including biotechnology, medical devices, and pharmaceuticals. The HQH fund's goal is to deliver long-term capital appreciation by focusing on smaller emerging companies with above average growth. The HQH fund may have up to 40% of its assets invested in restricted securities of both public and private companies.

HQH has $954 million in assets and charged a 1.19% expense ratio in fiscal 2022.

Strategy

The HQH fund invests in both public and private equities and other securities of companies across the healthcare industry. While allocations between various subsectors can vary, the HQH fund typically invest a significant percentage of assets in the biotech subsector, representing 50-65% most of the time.

The HQH fund may also write call options to generate additional income.

Portfolio Holdings

Figure 1 shows HQH's asset allocation and subsector allocation as of December 31, 2022. The vast majority of the fund's assets are invested in common stocks (88.1%), with 7.1% invested in convertible preferred shares and 4.7% invested in short-term investments.

As detailed above, HQH's sub-sector allocation is dominated by biotech, which accounts for 56.9% of the portfolio as of December 30, 2022. Other notable subsector allocations are Pharmaceuticals at 20.0% and Healthcare Equipment at 6.8%.

Figure 2 shows the fund's top 10 holdings, which account for 41.0% of the fund.

As mentioned above, the HQH fund has a relatively high exposure to private companies. As of September 30, 2022, the HQH fund has $79 million in Level 3 assets (investments that have unobservable inputs, i.e. private investments), or 8.6% of net assets (Figure 3).

Private Investments Are High Risk/High Reward

In bull markets, pre-IPO private investments can offer extraordinary returns, often delivering multiples of invested capital. However, they can also be very risky. For example, within HQH's portfolio of private investments, we can see quite a few duds such as Amphivena Therapeutics, which has been effectively written down to zero, or Dynacure Convertible preferred shares, which have lost 70% of its value (Figure 4).

Overall, HQH's portfolio of private investments are being carried at $79.4 million as of September 30, 2022, vs. their $86.6 million cost of acquisition.

Returns

Figure 5 shows the HQH fund's historical returns. HQH has delivered modest long-term returns, with 3/5/10/15Yr average annual returns of 5.1%/4.4%/9.0%/9.2% respectively to February 28, 2023.

However, the HQH fund has significantly lagged the healthcare sector in general, as represented by the Health Care Select Sector SPDR Fund ( XLV ). XLV has returned 13.0%/10.5%/13.2%/11.4% respectively, on the same timeframes (Figure 6).

HQH's underperformance relative to the XLV may be due to the call-writing strategies that trade off 'upside' for premium income. Furthermore, HQH's higher allocation to the high-risk long-duration biotech subsector may have been detrimental to returns as the Fed's interest rate hikes have compressed valuation multiples for long-duration assets.

Distribution & Yield

The HQH fund has a managed distribution policy that pays quarterly distributions at a rate of 2% of the trailing NAV. Over the trailing 12 months, HQH has paid $1.65 in distributions or a trailing 9.1% yield (Figure 5). On NAV, HQH has a trailing 8.2% yield.

Unlike fixed income CEFs that mostly pays distributions out of net investment income ("NII"), HQH's distribution tends to be funded primarily out of realized gains (Figure 7).

Although HQH's distribution is not primarily funded from NII, I don't think investors need to be overly concerned, as the fund has historically 'earned' a 9.0% and 9.2% return over 10 and 15 years respectively, which should be sufficient to cover a 2% quarterly distribution.

However, in years when the fund earns less than 8.2% (2% quarterly annualized), the HQH fund will see a shrinking NAV, as the distribution outpaces earnings. In fact, the HQH fund's NAV peaked in July 2015 and has shrunk by 45% since, from a combination of poor returns (5Yr average annual returns of only 4.4%) and high distribution rate (Figure 8).

HQH vs. Other Tekla Funds

Having reviewed 3 Tekla funds to date, which one do I prefer? Comparing the fund structures, HQH has been in operation for the longest and has the lowest expense ratio. It also has the lowest turnover ratio (Figure 9).

With respect to annualized returns, we can see that the Tekla Healthcare Opportunities Fund ("THQ") has the highest 3 and 5Yr average annual returns. On the other hand, the Tekla Life Sciences Investor ( HQL ) has the highest 10Yr average annual return, mostly because of some strong performance years like 52% in 2013, 32% in 2014, 27% in 2019, and 20% in 2020. However, it is important to note that on all time frames, the Tekla funds underperform the XLV ETF in terms of total returns.

With respect to risk metrics, the THQ fund has the best 3 and 5Yr Sharpe Ratios, and has the smallest maximum drawdown. Once again, the Tekla funds underperform the XLV in terms of risk metrics, as the XLV has better Sharpe Ratios on both 3 and 5Yr time frames.

Comparing the fund distributions, the Tekla World Healthcare Fund ( THW ) has the highest distribution yield. However, investors should note that relative to the fund's 5Yr average annual returns, only the THQ has earned a higher 5Yr return than its distribution. In other words, THQ's distribution is the most sustainable relative to the fund's historical earnings power over 5 years.

Overall, the HQH fund does not excel compared to its sibling funds. Aside from some strong performance years in 2013 and 2014, HQH has generally underperformed other Tekla funds, especially in the past 5 years. It pays a middle of the pack distribution yield of 8.2%, which appears high compared to how much the fund has earned in the past 5 years. However, it does have the lowest expense ratio of the four Tekla funds.

For investors who want to earn a consistent return and a steady and high distribution, I would recommend they consider the THQ fund, as it has the highest 3 and 5Yr average annual returns of the Tekla funds while paying a 6.4% of NAV distribution. For investors who want the highest total returns, I would recommend they look at the XLV ETF, as it has consistently outperformed the Tekla funds on long-term time frames.

Conclusion

Tekla Healthcare Investors is a closed-end fund aiming to provide long-term capital appreciation through investments in the healthcare industry. The HQH fund generally has a high allocation to risky biotech stocks, as well as private investments. Although the fund's 2% quarterly distribution does not appear too high, investors should note that the fund has not 'earned' this distribution in the past 5 years. Comparing HQH to its sibling Tekla funds, I prefer the THQ due to its steadier performance and more sustainable distribution.

For further details see: