THQ - THQ: Still The Best Of The Tekla Suite

2023-09-06 15:08:20 ET

Summary

• Tekla Capital manages four healthcare-focused closed-end funds.
• Of the four funds, I continue to believe the Tekla Healthcare Opportunities Fund is the most attractive, as its distribution yield appears most sustainable.
• A pending merger between the investment manager and abrdn should have no short-term implications. But investors need to be on the lookout for a retirement of the lead manager.

It's been a few months since I last reviewed the Tekla suite of healthcare-focused closed-end funds ("CEF"). Since my articles earlier in the year, abrdn plc has announced plans to acquire Tekla Capital Management. Will this merger have any impact on the Tekla funds? Also, is the Tekla Healthcare Opportunities Fund ( THQ ) still my favorite within the Tekla family?

Brief Fund Overviews

Tekla Capital Management is a boutique healthcare investment specialist based in Boston, Massachusetts and is the investment adviser for four closed-end funds: Tekla Healthcare Investors ( HQH ), Tekla Life Sciences Investors ( HQL ), Tekla Healthcare Opportunities Fund, THQ, and Tekla World Healthcare Fund ( THW ). The Funds predominately invest in the securities of public and private healthcare companies (Figure 1).

The main difference between the Tekla funds lies in their sub-sector exposures and risk profiles. The HQH and HQL funds are riskier funds as they have larger bets in the boom/bust Biotechnology sub-sector and also much higher exposures to private investments.

THQ and THW are broader healthcare sector funds, with the main difference being THW has a global focus while THQ is domestic U.S. focused.

Management Team

Tekla is led by Dr. Daniel Omstead, a successful healthcare entrepreneur who was formerly President and CEO of ReproGenesis, Inc., a development-stage biotech company that was merged into Curis, Inc. ( CRIS ) in 2000.

In addition to Dr. Omstead, the investment team at Tekla includes two medical doctors and four PhDs (Figure 2).

Returns Comparison

Moving on to the funds' returns, we can see that 2023 has not been a good year so far for the Tekla funds, with the best-performing fund being THW at 1.9% YTD to August 31, 2023. The other 3 Tekla funds have been more or less breakeven so far this year (Figure 3).

Tekla's poor performance is more a reflection of the healthcare sector, which has returned -1.2% YTD, as modeled by the Health Care Select Sector SPDR Fund ( XLV ).

However, looking at longer-term returns, the THQ fund still has the best 3 and 5Yr historical returns. Moreover, comparing 5-year returns to the funds' stated distribution yields, the THQ fund is the only Tekla fund where 5-year returns (6.7%) are comparable to the distribution yield (7.2%).

In general, funds with a large difference between average annual returns and distribution yields are called 'return of principal' funds. I recommend investors avoid 'return of principal' funds as they tend to have amortizing NAVs, which leads to decreased share prices and puts future distributions at risk.

While returns YTD have been disappointing for THQ, I believe it is still the best of the Tekla funds as it has the most sustainable distribution yield and the highest Sharpe ratios.

My analysis is confirmed by Morningstar, which has awarded 4 stars to the THQ fund, the highest among the Tekla funds (Figure 4). For comparison, THW has 3 stars, HQH has 2 stars, and HQL has 1 star.

Implications Of Proposed Takeover By abrdn

As mentioned above, on June 21st, abrdn plc, a UK-based global asset manager with more than £500 billion in assets under management including £24 billion in CEFs, agreed to acquire Tekla Capital Management. As part of the transaction, Tekla's investment team will be joining abrdn to build out abrdn's offerings in the healthcare sector.

For investors of the Tekla funds, there is no immediate day-to-day impact from the pending merger, as this is simply an acquisition of the investment manager and not a merger of funds. However, investors do need to approve the new investment advisory agreement struck with abrdn instead of Tekla Capital. Judging by the repeated adjournments of the special meeting to approve the new investment advisory agreement, investors appear to be lukewarm on the deal.

To be honest, I do not have a high opinion of abrdn. Of the handful of abrdn funds that I have reviewed to date (AOD, FAX, FCO, ACP, AWP), they all share the common characteristic of being 'return of principal' funds that pay more in distributions than the fund earns in average annual returns, leading to amortizing NAVs and share prices (Figures 5 to 9). So it is understandable if investors are not enthused about abrdn taking over management of the Tekla funds.

Is This Management's Exit Strategy?

More importantly, I believe the sale of Tekla Capital to abrdn could be a sign that key members of Tekla's investment management team are 'cashing out'. For example, Dr. Omstead, the driving force behind Tekla for the past 2 decades, is 70 years old, and this transaction may pave the way for him to retire after a transition period.

Investors in the Tekla funds post-merger should be on the lookout for signs that Dr. Omstead may be stepping away, as a change in the investment manager can significantly alter the risk/reward profiles of funds.

Conclusion

Overall, I continue to believe the Tekla Healthcare Opportunities Fund is the most attractive of the four Tekla closed-end funds available. The THQ fund is a broad healthcare sector fund that pays a sustainable distribution yield, whereas the other Tekla funds are all paying more than they earn.

In the short-run, the pending merger between abrdn and Tekla Capital should have no impact on the day-to-day management of the Tekla funds. However, I think investors should be on the lookout for signs that Dr. Omstead, the driving force behind Tekla for 2 decades, may be preparing to retire. If that happens, they need to reconsider whether they should continue to own the Tekla funds in my view.

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