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Healthcare And Biotechnology Closed-End Funds

Summary Tekla offers four closed end funds in the biotechnology/healthcare sector. Two long-established funds are focused on capital growth. Two newer funds add current income to their investment objectives. Healthcare and Biotechnology seem to have caught their stride after a rough third quarter. There are a lot of ways to invest in these sectors. One of the least appreciated is closed-end funds, and the best of these, in my opinion, come from Tekla. Tekla sponsors four funds. Two are well established funds that are regularly found at or near the top of the pack for equity CEFs. Two are new, one a little more than a year old and the other a little more than a quarter. The stalwarts are Tekla Healthcare Investors (NYSE: HQH ) and Tekla Lifesciences Investors (NYSE: HQL ). The new-comers are Tekla Healthcare Opportunities (NYSE: THQ ) and Tekla World Healthcare (NYSE: THW ). Some descriptive details for these funds are in the table. The two older funds operate much the same. They are unleveraged and have managed distribution policies for their quarterly distributions. The younger funds are structured differently from the older funds, but are similar to each other. For one thing, they use leverage to achieve their investment goals. Precisely what the extent of that leverage may eventually be is unclear. THQ is reporting 9.6% leverage at present, and THW is too new to have reported. THQ and THW also have managed distribution policies, but theirs are structured differently from HQH and HQL. They pay distributions monthly. Investment Goals HQH invests in the healthcare industry (including biotechnology, medical devices, and pharmaceuticals). The fund’s objective is to provide long-term capital appreciation through investments in companies in the healthcare industry believed to have significant potential for above-average long-term growth. Selection emphasizes the smaller, emerging companies with a maximum of 40% of the Fund’s assets in restricted securities of both public and private companies. HQL primarily invests in the life sciences (including biotechnology, pharmaceutical, diagnostics, managed healthcare, medical equipment, hospitals, healthcare information technology and services, devices and supplies), agriculture and environmental management industries. The Fund’s objectives and selection criteria are the same as HQH except for a change in wording from healthcare to the life sciences industry. Note that biotechnology heads the lists for each. To a large extent these are primarily biotech funds. One particularly interesting point is that the funds can and do invest in private companies. This can open opportunities not generally available to most investors, and certainly not readily accessible by investing in open-end mutual funds or ETFs. The difference between HQH and HQL is that HQL’s mandate is expanded to include agricultural and environmental biotechnologies. THQ and THW invest primarily in the healthcare industry. The funds’ objectives are to seek current income and long-term capital appreciation through investment companies engaged in the healthcare industry, including equity securities, debt securities and pooled investment vehicles. Notice that HQH and HQL make no mention of current income in their goal statements and THQ and THW do. Notice also, that THQ and THW include debt securities in their investment strategies. THW differs from THQ in being targeted more as an international fund. It expects to invest at least 40% in companies organized or located outside the United States. Both expect to invest in debt securities and pooled investment vehicles in addition to equity. So there are marked differences between HQH and HQL on one hand, and THQ and THW on the other. HQH/HQL are more closely focused on biotech; THQ/THW invest more broadly in the healthcare sector. The first set does provide excellent income, but that is not its purpose, which affects how the fund is managed. Finally the new funds expand their investment programs to include debt securities such as convertible and non-convertible bonds and preferred shares. Distribution Policies All four have managed distribution policies, but the terms of the policies are different. HQH and HQL have as their distribution policy the intention to make quarterly distributions at a rate of 2% of the fund’s net assets. To the extent possible, they will to do so using net realized capital gains. If those gains fall short of the target this could result in return of capital to shareholders. Capital gains in excess of distributions will be returned to shareholders as a special distribution with the December distribution. The default for HQH’s and HQL’s distributions is that they are taken in stock. Investors do have the option to request cash distributions. This policy reflects the funds’ emphases on capital appreciation rather than current income, and is unusual for CEFs. Both HQH and HQL began making quarterly distributions in 2000 (previous to that they were made annually). Both suspended distributions for three quarters in 2009-10 making no payment between June 2009 and June 2010. Otherwise, the funds have met their 2% of NAV payout objective without return of capital for all but two of the 60 quarterly payments they have made. Distributions for Q1 and Q2 of 2009, the quarters prior to the suspension of distributions did include return of capital. THQ and THW have current income as an investment objective. Their managed distribution policies are more similar to that of other managed-distribution CEFs. Although I have not seen it explicitly stated in the materials I’ve viewed, I assume that it means the funds expect to maintain consistent monthly payments independent of fluctuations in NAV and income, which is the most typical pattern of managed distributions. This can mean distributions that include return of capital and periodic occurrences of negative undistributed net investment income. THQ has paid $0.1125/share monthly since inception. THW has paid $0.1167/share for its three distributions. Current Status The two older funds are currently priced at premiums near 5%. The new funds have double-digit discounts as seen in this table. The distribution percentages shown in the table are based on recent payouts. According the funds’ policies the next distribution for HQH and HQL will be 2% of NAV on the record date. Z-Scores give us an indication of where the discount/premium stands in relation to the past. Positive Z-Scores mean the discount has shrunk or the premium has grown over the period. The absolute value represents the number of standard deviations the current value is relative to the average for the period. Large Z-scores (say, over 2 or under -2) can often suggest mean reversion is imminent. These values tell us that for HQH and HQL the premiums stand well above their means for 3, 6 and 12 months. As recently as the end of September, HQH had a -8.85% discount and HQL’s was -6.2%. Both funds have seen volatile pricing relative to NAV recently and have seen their discount/premium fluctuate widely. This is seen in HQH’s chart (from cefconnect.com ). (click to enlarge) During the third quarter meltdown for healthcare and biotechnology there was near-panic selling of the fund causing the discount to fall below -8%. With signs of recovery in October, the premium has been restored. These are the sorts of movements that some CEF investors look for and hope to take advantage of when they do occur. Portfolios HQH and HQL have very similar portfolios. HQL nominally adds exposure to agricultural and environmental biotechnology to HQH’s pure play in healthcare but this not obvious without getting deep into the fund’s holdings. At the top it looks very much like HQH. HQH holds 96% in equity; for HQL it’s 92%. The remainder is primarily in debt instruments. THQ holds 18.5% of its portfolio in debt instruments. THW’s portfolio remains a black box at this time, as there have been no reports as yet by the fund. Top holdings are available for HQH, HQL and THL but not for THW. (click to enlarge) Note how similar HQH and HQL’s lists are. The clear emphasis here is on biotechnology. THQ has positions extending beyond biotechnology to include more traditional healthcare companies such as Johnson & Johnson and Pfizer which is consistent with its more explicit emphasis on income. Other Healthcare CEFs My focus here has been on the Tekla offerings with the intention of clarifying how the new funds differ from the established funds. Before closing, I would be remiss to not mention two other healthcare CEFs; BlackRock Health Sciences (NYSE: BME ) and Gabelli Health & Wellness (NYSE: GRX ). BRE is more similar to HQH and HQL in that it is unleveraged and entirely domestic, but its focus is less on biotechnology than those funds. GRX carries 20.5% effective leverage and has a more diverse portfolio that includes food companies such as Kraft Foods and Kikkomann Corp as well as heathcare holdings. It is 84% domestic and 15% Developed Europe and Japan. BME, like the older Tekla funds shows extensive movement in its premium/discount. It now stands at a 7% premium, up from its 52 week average but well below its 52 week high of 16.2%. GRX, by contrast, tends toward a persistent discount which is now -13.2%, near its 52 week low of -14.8%. BME recently has tended to perform comparably to the Tekla funds; GRX has consistently lagged. Over a longer time frame the Tekla funds have turned in much stronger performances than either BRE or GRX, likely a reflection of their emphasis on biotechnology over traditional healthcare companies. This is illustrated by this chart tracking total return for the past two and five years. (click to enlarge) Summary The two sets of Tekla funds, HQH and HQL on one hand, and THQ and THW on the other, have different objectives and approaches to healthcare and biotechnology investing strategies. HQH and HQL are primarily focused on generating capital appreciation. The younger funds are more in the traditional CEF mold of emphasizing current income as well as capital appreciation. Despite the lack of formal emphasis on income, the distribution policies of HQH and HQL are, in my view, primarily attractive to an investor interested in current income. Their distribution yields are attractive and growing with NAV growth. For a shareholder invested for capital appreciation, the distributions can raise tax issues, so the funds are probably best held in a tax-advantaged account in such cases. In a taxable account, it would seem to make more sense to use ETFs to provide exposure to biotechnology to satisfy a capital growth objective. ETFs can effectively provide that capital appreciation with much lower taxable distributions. The premiums for HQH and HQL argue against entry into these funds at this time. A patient investor would probably choose to wait for some reduction in the premiums, if not outright reversion to discount status. Those premiums are now approaching all-time highs for HQL and are at rarely seen levels for HQH. An income investor seeking exposure to healthcare with a biotech focus may find THQ more appealing than either HQH or HQL at this time. There is, of course, only a scant record for the fund. Tekla has shown itself to be a strong manager of biotech equity portfolios but has little record in expanding that to include debt and credit. The discount of -11.6%, about as deeply discounted as the fund has been in its short life, looks to provide an attractive entry. As for THW, the fund is too young and information too scanty to appeal to me at this time. I suspect it will evolve to be as similar to THQ as HQL is to HQH.

Tekla Life Sciences Investors Fund: Good Performer, But Not A Reliable Income Play

Summary Tekla Life Sciences Investors Fund has a solid long-term performance record. But HQL and its dividends can be volatile. Still, if you like healthcare and are willing to take on some biotech risk, you might want to take a look at this CEF. Tekla Life Sciences Investors Fund (NYSE: HQL ) has an impressive long-term performance record, which is probably why a frequent reader asked me to take a look at it. However, what it doesn’t offer is a consistent distribution. Although that might scare off income-oriented investors, it’s still worth a deep dive for anyone thinking about investing in the life sciences space. But risk is the key word here. What the fund does HQL is a closed-end fund, or CEF, that invests in the life sciences arena. What exactly does that mean, particularly since the fund’s siblings invest in similar securities? Well, according to the fund, it can invest in areas such as biotechnology, pharmaceutical, diagnostics, managed healthcare, medical equipment, hospitals, healthcare information technology and services, devices and supplies, and agriculture and environmental management industries. Up until the last two, the fund sounds like your run-of-the-mill healthcare offering. The thing is, siblings Tekla Healthcare Investors (NYSE: HQH ) and Tekla Healthcare Opportunities Fund (NYSE: THQ ) have broad enough mandates that there’s some overlap in what each invests in and there’s notable overlap in their top holdings. So it’s hard to suggest that HQL is a massively differentiated fund within the family. But that doesn’t mean it isn’t different. For example, at the end of March, HQL had the heaviest weighting of the three funds in biotech and biopharmaceuticals at roughly 60% of assets. Its siblings HQH and THQ had around 50% and 35%, respectively. That really makes THQ the most aggressive of the trio, something that has been a boon to performance over the last few years. For example, the fund’s net asset value, or NAV, total return was 42% over the last 12 months through the end of May. (Total return includes the reinvestment of distributions). Over the trailing three- and five-year periods, its annualized total return was roughly 35% and 31%, respectively. That’s a heck of a showing. In fact, in March, management made note of the strong performance, warning investors that: “…we are favorable on the fundamentals of the healthcare and biotech sectors. However, we also want to express a note of caution. After several years of outperformance, valuations in the healthcare and biotech sectors, while reasonable relative to other sectors on a growth adjusted (P/E divided by G) basis, they are high on a trailing twelve month Price/Earnings basis.” In other words, we like the space, but don’t be surprised if there’s a pullback. Some things to note It’s also worth noting that the fund has the leeway to invest up to 40% of assets in “restricted” securities. Such illiquid investments are usually, though not exclusively, start-ups that need cash but aren’t publicly traded. These securities have to be valued by management, even though there’s no ready market for them. This is a risk you should keep in the back of your mind if there is a notable downturn. That said, the fund doesn’t make use of leverage, which means a downdraft wouldn’t be exacerbated by debt. The fund doesn’t use options, either, so it is a pure-play stock fund. Taking these facts a step further, it means that the fund’s distributions have to be covered by dividends, interest, and trading activities. The fund’s distribution policy is to pay 2% of its net asset value per quarter to shareholders. On an annual basis, that means a roughly 8% distribution target. That’s high enough to be meaningful, but low enough that you can probably expect long-term performance to make up for difficult periods that may require distributions to be paid out of capital. Clearly, with such solid performance, that hasn’t been an issue of late. In fact, since 2010, the fund’s NAV has done nothing but go up every year. And in a big way, too. At the start of the decade, the NAV was roughly $11.30, while more recently, the NAV was in the $29 range. That’s even more impressive when you consider that it’s paid out around $7 a share in distributions over that span. The only problem here is that the distribution isn’t a reliable figure; it bounces around with the fund’s NAV because of the 2% per quarter policy. In other words, you can’t count on the distributions paid over the past year to be any indication of what will be paid in the future. And, perhaps more important, just when you may be most in need of stable income, like during a market downdraft, the fund’s distribution is likely to shrink. For income-focused investors, then, this is a big risk to note. Expense-wise, HQL’s costs are currently running at around 1.25% of assets. That’s down from a few years ago, when the number was 1.7%. So it’s not overly expensive to own today, but it has been in the past considering that it doesn’t use leverage or options. To be fair, however, it was a much smaller fund in the past than it is today. Own it, don’t own it? On the whole, HQL is a decent fund. At present, it’s heavily focused on the biotech space, but for an aggressive investor, that might be exactly what’s desired. However, that brings the issue of risk to the fore, which is the big-picture consideration here. Despite a solid performance record over the past few years, this fund isn’t for the faint of heart. Biotech is an often volatile space and HQL is heavily invested there. What’s this mean? Vanguard Health Care Fund (MUTF: VGHCX ), a more broadly diversified mutual fund, had a standard deviation, a measure of volatility, of around 9 over the trailing three- and five-year periods. HQL’s standard deviation over those spans was 15. These two funds aren’t apples to apples, nor are they apples to oranges. For investors looking at the healthcare sector, HQL is a risky option. Moreover, anyone looking specifically for income shouldn’t be expecting a steady flow of distributions from HQL. Indeed, the fund’s policy specifically builds in distribution cuts during bad times. If you can stomach those two risks, HQL’s shares currently trade at an around 2% discount to NAV. That’s not particularly large, but is in line with its recent past. The discount has been much wider, coming in at an average of more than 5% over the trailing five years, according to the Closed-End Fund Association . Over the trailing 10 years, the average discount was nearly 8%. So while investors aren’t bidding the shares up beyond NAV, there’s room for negative sentiment to push them down further than they are at present if history is any guide. And if biotech goes out of favor, I’d expect that to happen. Would I buy HQL? No. I would be more comfortable with a fund that’s more diversified. However, that doesn’t mean it’s a bad fund for someone with a more aggressive bent. Just make sure you know what you are buying when you go in. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.