THQ - THW: abrdn Takes Over Fund Drops To Massive Discount But THQ Still Looking Better

2023-10-30 15:17:12 ET

Summary

• abrdn has taken over the management of the former Tekla funds, and they've dropped to some meaningful discounts.
• Both the abrdn World Healthcare Fund and the abrdn Healthcare Opportunities Fund represent attractive investment opportunities, but I would tend to favor THQ.
• THW has a higher distribution rate when compared to THQ, which can have some appeal for some investors, but both funds will rely entirely on capital gains going forward.

Written by Nick Ackerman, co-produced by Stanford Chemist.

As of the close of business on October 27, 2023, abrdn has taken over the management of what was formerly Tekla World Healthcare Fund. However, that has now been renamed as the abrdn World Healthcare Fund (THW). Some investors were cautious over the takeover of abrdn, but Tekla's managers actually came along with the transition. A larger fund sponsor also has the benefit of more resources, so I wasn't overly concerned.

Upon the close of business on October 27, 2023, the investment team responsible for the management of the Funds joined abrdn. The Funds will continue to be managed in accordance with their existing investment objectives and strategies by the same team of Boston-based investment professionals pursuing the same investment philosophy and employing the same investment process that has served the Funds well through the years.

All that being said, this wasn't going to be the main focus of my article. It just so happened to coincide with the fund dropping to an absolutely massive discount - at least relatively speaking.

However, its sister fund, the now-named abrdn Healthcare Opportunities Fund (THQ) (formerly Tekla Healthcare Opportunities Fund,) is also representing an attractive opportunity as well. One that I would continue to favor at this time.

THW Basics

• 1-Year Z-score: -4.14
• Discount: -9.56%
• Distribution Yield:13.64%
• Expense Ratio: 1.52%
• Leverage: 22.44%
• Managed Assets: $534.7 million
• Structure: Perpetual

THW's investment objective is "to seek current income and long-term capital appreciation." The fund employs a "versatile growth and income investment strategy investing across all healthcare subsectors and actors a company's full capital structure. THW invests at least 40% in ex-U.S. companies or those with substantial ex-U.S. revenues."

THQ Basics

• 1-Year Z-score: -3.27
• Discount: -18.89%
• Distribution Yield: 8.66%
• Expense Ratio: 1.46%
• Leverage: 22.35%
• Managed Assets: $1 billion
• Structure: Perpetual

THQ's investment objective is "to seek current income and long-term capital appreciation." The fund employs a versatile growth and income investment strategy investing across all healthcare sub-sectors and across a company's full capital structure."

As you can see, both the funds have substantially the same approach, but THW's goal is more global. Hence the "world" portion of its name. They offer some overlap, naturally, but otherwise, they are slightly different approaches.

Both the funds also employ leverage, which has been a headwind in a rising rate environment as those costs have increased. They are fairly modestly leveraged, as both have a target leverage ratio of 20%. The rate for the borrowings is calculated as SOFR plus 0.75%. That's the same for both funds, and with SOFR at 5.31% , borrowings are now pushing to over 6%.

On top of employing borrowings, the funds will also utilize writing options. For THW, the fund also uses forward contracts and foreign currency transactions in order to hedge its global exposure.

Is THW A Bargain Yet?

THW had, for quite a few years now, traded at a substantial premium. That's why I haven't really revisited this fund too much. My last coverage was in December 2021. Since then, the fund has done poorly, but so has the overall equity market.

A significant portion of this drop is actually just from the fund's ~6% premium at that time, coming down to around a 9.5% discount today. Throughout most of this time, I've favored THQ for its more attractive valuation - and today, that hasn't changed.

THW's 1-year z-score of -4.14 obviously tells us that in the short term, THW seems to be absolutely oversold. Still, THQ hasn't fared any better, and that fund has dropped to an almost 19% discount and has pushed its 1-year z-score to -3.27. This still represents an incredibly attractive discount to consider the healthcare fund, and it is a fairly rare event to see a fund's discount widen that materially.

Both funds have dropped below their long-term average discount levels in a substantial way. However, the question here is if THW deserved to trade at such a premium in the first place.

It didn't seem warranted, at least in terms of performance, where, over the long term, THQ had been the better performer on a total NAV return basis.

This is where being positioned with more global exposure has tended to hurt the fund historically. That doesn't always mean that the performance going forward will always favor THQ.

In fact, we have to give credit where it is due; over the last year, THW has outperformed. Unfortunately, both funds over the last year have taken a hit and are lower as healthcare hasn't necessarily been the most attractive place to invest.

Another area that investors are likely to get excited is in terms of the distribution rate. For THW, it's a meaningfully higher payout.

On a NAV basis, THW's distribution rate comes to 12.62%, and THQ's comes out to 7.02%. Of course, the problem with the higher distribution rate is that THW hasn't been earning it. Historically, THQ is now at a level with this latest slump where its past total returns also indicate that it is underearning its distribution, with the last five years total NAV returns coming in at 5.60%

The other indication of not earning a payout for equity-focused funds is looking at their NAV levels. THQ launched with an NAV of $19.06, and it slumped to $18.90 more recently. Again, with this latest slump, healthcare pulls back over 9% in 2023.

However, when compared to THW, we see the fund launched with an NAV of $19.06 as well, and today, it is $10.88. Both funds have maintained the same distributions since they launched, which is almost an identical monthly amount. THQ's monthly payout is $0.1125 and THW's is $0.1167.

Again, this is another way to measure if a payout is being earned, and in this case, it is quite clear that it isn't.

With that being said, abrdn has a history of allowing their CEFs to overpay distributions. Funds such as abrdn Income Credit Strategies Fund ( ACP ), abrdn Global Income Fund ( FCO ) and abrdn Global Premier Property ( AWP ) come to mind. AWP cut just prior to Covid and ACP cut during Covid.

However, they have since continued to maintain the current distribution rates without cutting further in the face of deteriorating conditions. The cuts, in my opinion, are only a matter of time. Still, it shows that the fund sponsor might not be so quick to persuade THW to right-size its distribution.

For THQ at around a 7% NAV rate, which is quite reasonable, and I wouldn't foresee a cut for the foreseeable future. Given the massive discount there, the payout to shareholders comes to 8.66%.

In the end, your real return is going to be whatever the funds can produce in terms of primarily capital gains anyway. Neither fund can generate enough income from their holdings to cover their payouts. THW's last semi-annual report showed no net investment income at all as the cost of leverage ate through the total investment income. That was the same with THQ, which also saw a negative NII in their last semi-annual report .

Conclusion

Overall, discounts have widened substantially in the closed-end fund space as we've gone through 2023. The greater volatility more recently, with the market entering correction territory as defined by a 10% or greater drop from highs, certainly hasn't helped either. CEFs going back to 1996 have only been at larger discounts 2% of the time.

THW's fall certainly looks dramatic since it came at such speed and coming from a premium to what could be considered a massive discount now. However, THQ still looks like the more attractively valued fund despite the lower distribution rate being paid out.

Given the higher rate environment is expected to be here for a while, there doesn't appear to be a way to help support their distributions as NII is likely to remain negative. So, whether you are looking at THW's 13.64% rate or THQ's 8.66% rate, that won't change the end results - only capital gains will matter, and that will be watching where the NAV trend goes. Starting at a deeper discount, in this case, makes sense, at least to me and is why I'd continue to favor THQ.

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