SPY - Sell THW Buy XLV Or THQ

2023-06-29 13:45:56 ET

Summary

• Healthcare is undervalued today and many picks offer good prospects.
• Tekla World Healthcare Fund though is possibly the last way you should make that bet.
• We tell you how the fund has done and why you would have been far better off elsewhere.
• We give our minimum criteria for removing our sell call.

Healthcare has been a relative underperformer in the past year. As investors have flocked to the latest growth stories, the predictable earnings of this defensive sector have held less value for investors. We look at one fund in this sector today that is extremely popular with investors and tell you if it meets our investment criteria.

Tekla World Healthcare Fund ( THW )

THW is closed end fund and one that makes it clear that it is focused on producing income.

Tekla World Healthcare Opportunities Fund (“THW”) is a non-diversified closed-end healthcare fund traded on the New York Stock Exchange under the ticker THW. THW employs a versatile growth and income investment strategy investing across all healthcare subsectors and across a company’s full capital structure. THW invests at least 40% of AUM in ex-U.S. companies or those with substantial ex-U.S. revenues.

Source: THW

The fund was started in 2015 and has met one of its objectives by paying a consistent monthly distribution of $0.1167 ($1.40 annually).

Fund Holdings

The fund is run in a top-heavy manner with the highest 10 holdings amounting to about 40% of the total. On the list we find familiar names like Johnson & Johnson ( JNJ ), Pfizer Inc. ( PFE ) and Eli Lilly and Company ( LLY )

The top 10 outside of UnitedHealth Group Inc. ( UNH ) make THW look like a pharmaceutical fund. That is definitely not the case. It appears the bulk of the pharmaceutical exposure is confined to the top 10 holdings. Overall, this subsector makes up 40.8% of the total. The fund has the next highest allocation to healthcare providers. Overall, the fund does work more or less as a diversified healthcare fund.

One twist here is that common stocks form only 83.5% of the total. The fund's debt exposure reduces some of the volatility you would see in a full equity fund.

Fees

The fund is not cheap by any stretch of the imagination. With 1.91% in fees, the bar is already high to invest in this.

One point to note here is that on last check, the interest expense was 0.39%. Leveraged assets were at 20% of total.

Our point is that the expense ratio is extremely backward looking.

Starting January 29, 2022, the Fund is charged interest at the rate of 0.75% and a SOFR Adjustment above the relevant SOFR rate. The Fund is also charged a commitment fee on the daily unused balance of the line of credit at the rate of 0.10% (per annum). Per the Line of Credit agreement, the Fund paid an upfront fee of 0.05% on the total line of credit balance, which is being amortized through January 29, 2023. The Fund pledges its investment securities as the collateral for the line of credit per the terms of the agreement. The weighted average interest rate and the average outstanding loan payable for the period from October 1, 2021 to September 30, 2022 were 1.6795% and $120,000,000, respectively. The stated carrying amount of the line of credit approximates its fair value based upon the short term nature of the borrowings and the interest rates being based upon the market terms.

Source: Annual Report - THW

It is based on an average of 1.67% interest rate charge. We are now past 6.0%. So in real time, the interest expense ramps to over 6% on the leverage and annualizes currently over $7.2 million. Hence the 0.39% jumps to over 1.5% and total expense ratio goes sailing past 3%. We will note that even the next annual report won't show that as it averages a 12-month period. We are giving real-time information that impacts your investments today though.

Performance

As the fund is a closed end fund, with very specific characteristics, an exact comparative/benchmark is hard to find. But Health Care Select Sector SPDR ( XLV ) is one that we think comes close. Two main criteria sway our thinking here. First, have a look at the top holdings and note the substantial overlap with THW.

Next, we would note the allocations to the various subsectors by XLV. THW has an overweight on Pharmaceuticals on a relative basis but we can certainly use XLV as a rough benchmark.

How has THW done relative to XLV? Not too well. We threw in S&P 500 ( SPY ) and a sister fund, Tekla Healthcare Opportunities Fund ( THQ ) as comparatives.

THW was the worst of the bunch and particularly notable was that it lagged XLV by 55%. This 55% lag has happened in exactly eight years (THW was launched on June 30, 2015). That is pretty huge. Investors might be getting enamored with the distributions from THW versus XLV, but a systematic withdrawal from XLV would outperform substantially.

Outlook & Verdict

We like healthcare and think it is one of the relatively cheaper sectors in the market. Of course, stock picking is critical. There is a big difference between where PFE and LLY stand today, for example.

THW though, is a difficult name to get behind. The fund has massively underperformed XLV. While some of this comes from its higher international exposure and a larger overweight to pharmaceuticals, the 7% annual lag is hard to look past. Total expense ratio will be higher than 3% and that compares to just 0.10% for XLV. Yes, THW adds leverage and interest expenses will obviously be high for that portion. But the last eight years have shown that XLV could not use it to its advantage even when that interest expense was peanuts. We remain skeptical they will clear a 6% hurdle rate today meaningfully.

We want to end with a couple of important points for the "income investors". First, the total return shown on all calculators assumes you reinvest your distributions. So if you don't reinvest your returns are even lower.

Astute investors might have noticed the difference between $1,526 (52.6% total return implied) and 39.96% shown earlier. That difference comes from the 52.6% being Total Return On Price and the 39.96% being Total Return On NAV.

That gets us to our second point. The reason Total Return On Price is higher is because you are paying 12.58% premium (sorry we have to break for a laugh here) for this really poor performance. The fund did trade at a discount for most of the ZIRP (zero-interest rate policy) era. Paradoxically, we are now attaching the highest premium to this fund at the worst possible time with high rates.

So our verdict is to Sell THW today. The high premium is likely to unwind with a gusto at some point leading to really poor returns from here. THW gets a 10 on our potential pain scale rating.

We would use the funds to switch to XLV, which we think continues to outperform. XLV gets a 4 on our potential pain scale rating.

At a minimum, we would wait till THW moves to a discount before purchasing it. If you want a fund from the same family, THQ which has beaten the pants off THW and sells at an 11% discount.

It also offers a slightly lower yield of 7.21%. The irony is that both have maintained the same distributions since inception and THW's higher yield relative to THQ comes thanks to massive underperformance. THQ gets a 4 on our potential pain scale rating.

One final note as we leave. Both funds are likely to move under the abrdn umbrella. Our read on that is nothing will materially change for their day to day management and this news does not change our relative outlooks for the funds.

Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.

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