HQL - HQL: Boom-Bust Returns May Not Be Suitable For High Distribution Yield

2023-03-08 03:27:02 ET

Summary

• HQL focuses on the life sciences industry with a 74% allocation to biotechnology stocks.
• It pays a 2% quarterly managed distribution.
• The boom-bust nature of biotech stocks may not be suitable for a steady managed distribution strategy as it under-earns in most years.

Recently, I wrote an article on Tekla Healthcare Investors ( HQH ). In the article, I compared and contrasted HQH with its sibling funds Tekla Healthcare Opportunities Fund ( THQ ) and Tekla World Healthcare Fund ( THW ). This article completes my review of the Tekla family of funds by analyzing Tekla Life Sciences Investors ( HQL ).

HQL is a closed-end fund focused on investments in the life sciences industry, especially risky biotechnology stocks that make up 74% of its portfolio. This leads to a 'boom-bust' returns profile that may not be suitable for high distribution strategies.

Fund Overview

Tekla Life Sciences Investors is a closed-end fund ("CEF") focused on the life sciences industry, including biotechnology, pharmaceutical, diagnostics, medical equipment, and other related sub-sectors. The HQL fund focuses on small, emerging high growth companies in the life sciences industry, especially biotechnology companies. The HQL fund may invest up to 40% of its assets in restricted securities of both public and private companies.

HQL has $419 million in assets and charged a 1.38% expense ratio in fiscal 2022.

Strategy

Tekla funds are all lead managed by Dr. Daniel Omstead, formerly President and CEO of Reprogenesis, Inc., a development stage biotech company that was merged into Curis, Inc. ( CRIS ) in 2000. Dr. Omstead also has research experience with Merck and Johnson & Johnson. In addition to Dr. Omstead, Tekla's investment team also includes medical doctors and PhD scientists.

Out of the 4 Tekla funds, I consider Tekla Life Sciences Investors the riskiest, as it has the highest allocation to the biotechnology subsector. It also has the highest exposure to private investments. An overview of the four funds' allocations can be found in Figure 1 below.

Portfolio Holdings

Figure 2 shows HQL's asset allocation as of December 31, 2022. The vast majority of the fund's assets are invested in common stocks (86.7%), with 7.6% invested in convertible preferred shares and 4.1% invested in short-term investments.

As detailed in figure 1 above, HQL has the highest allocation to the Biotechnology subsector out of the 4 Tekla strategies at 74.0% of the portfolio. Other notable subsector allocations for HQL are Pharmaceuticals at 14.9% and Life Sciences at 4.4%.

Figure 3 shows the fund's top 10 holdings, which account for 50.0% of the fund.

The HQL fund has a relatively high exposure to restricted securities of public and private companies. As of the fund's annual report on September 30, 2022, the HQL fund had $38.5 million in Level 3 assets (investments that have unobservable inputs, i.e. private investments), or 9.3% of net assets (Figure 4).

Overall, HQL's portfolio of private investments is carried at $38.5 million vs. $40.8 million in costs, suggesting the fund has suffered some mark downs.

Returns

Figure 5 shows the HQL fund's historical returns. HQL has delivered modest medium-term average annual total returns of 3.7% on a 3 and 5Yr time-frame to February 28, 2023. However, HQL's long-term performance has been better, with 10 and 15Yr average annual returns of 9.3% and 9.7% respectively.

As I mentioned in my HQH article, investors should note that the Tekla funds have all lagged significantly behind the healthcare sector, as represented by the Health Care Select Sector SPDR Fund ( XLV ). XLV has returned 13.0%/10.5%/13.2%/11.4% respectively on a 3/5/10/15Yr time frame (Figure 6).

Most of the issue for HQL is its heavy allocation to the biotechnology subsector. Regardless of one's security selection or investment acumen, if a narrow asset class has performed as poorly as the biotechnology subsector, as represented by the SPDR S&P Biotech ETF ( XBI ), it is hard to generate positive returns (Figure 7). On a 1/3/5Yr basis, the XBI ETF has returned -7.8%/-2.4%/-1.6% respectively.

Distribution & Yield

Like the HQH fund, the HQL fund has a managed distribution policy that pays quarterly distributions at a rate of 2% of the trailing NAV. Over the trailing 12 months, HQL has paid $1.30 in distributions or a trailing 9.1% yield. On NAV, HQL has a trailing 8.0% yield.

Like HQH, HQL's distribution has been mostly funded out of realized gains (Figure 8).

Assessing whether HQL has 'earned' its distribution is a little complicated. From Figure 5 above, we can see clearly the fund has not 'earned' its distribution on medium-term timeframes of 3 to 5 years with only 3.7% annual total returns. In fact, looking at HQL's long-term NAV history, we can see a very distinct 'boom-bust' characteristic, with the HQL fund delivering phenomenal returns in the late 1990s and 2012-2015 (Figure 9).

However, aside from these brief periods, which coincided with booming investor appetites, HQL's NAV has tended to be sideways to down, suggesting it does not 'earn' high enough returns to fund its ~8.2% annualized distribution yield in those years.

In fact, one should question why a 'boom-bust' biotechnology strategy is paying a high managed distribution in the first place? Normally, one associates high yielding funds with stable, income generating investments, not risky biotechnology stocks. I think the HQL is a poorly designed product giving investors the illusion of stability from an asset class (biotechnology stocks) not known for generating consistent returns.

For investors who want to earn a consistent return and a steady and high distribution, I would recommend they consider the THQ fund instead, as it has a much more balanced subsector allocation, allowing it to generate consistent long-term returns that can fund its 6.4% of NAV distribution. Figure 10 shows a returns comparison table between the different Tekla funds. Notice THQ is the only one with 5Yr average annual returns higher than its current NAV distribution yield.

Conclusion

Tekla Life Sciences Investors is a closed-end fund aiming to provide long-term capital appreciation through investments in the life sciences industry. HQL has an extremely concentrated bet on biotechnology stocks, representing 74% of the portfolio. This leads to a 'boom-bust' returns profile that in my opinion is not suitable for high distribution strategies. For investors looking for consistent returns and distributions within the Tekla stable, I recommend they consider the THQ fund due to its steadier performance and more sustainable distribution.

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