Sean Anthony Eddy
Since I last wrote about the Tekla Healthcare Investors (NYSE:HQH) fund, management of the HQH fund has been taken over by abrdn, a global asset manager and the fund has also been renamed the abrdn Healthcare Investors fund in the process.
What impact, if any, does the takeover by abrdn have on HQH? With the HQH fund declining by 14% since my March article, has the outlook improved for the HQH fund?
Figure 1 – HQH has declined by 14% since March (Seeking Alpha)
abrdn Healthcare Investors is a closed-end fund (“CEF”) that invests exclusively in the healthcare industry, including bets on biotechnology, medical devices, and pharmaceutical companies. The HQH fund’s goal is to deliver long-term capital appreciation by focusing on smaller emerging companies that may deliver above average returns. The HQH fund may invest up to 40% of its assets in restricted securities of both public and private companies.
HQH currently has $885 million in assets and charged a 1.19% expense ratio in fiscal 2022.
As mentioned above, on October 27th, abrdn plc, a UK-based global asset manager with close to £500 billion in assets under management, completed its previously announced acquisition of Tekla Capital Management.
For investors of the HQH fund, there should be no immediate day-to-day impact from merger, as this is simply the former manager being acquired by abrdn, and not a merger of funds or change in strategy. Operationally, the funds will still be managed by Dr. Omstead and his team of investment professionals based out of Boston.
However, the HQH fund will see a shuffling in its board of trustees, with the addition of four newly elected trustees, including abrdn’s CEO, Stephen Bird, joining two existing trustees, Jeffrey A. Bailey and Kathlen L. Goetz.
Looking forward, what investors should keep an eye on is whether this sale of Tekla Capital Management represents Dr. Omstead’s ‘exit strategy’. Dr. Omstead has been at the helm of Tekla Capital Management since 2000 and at age 70, he may be close to retirement age.
A sale of the management company could be a convenient way for Dr. Omstead to ‘cash out’ his ownership and transition himself out of active management of the funds following a transition period.
As we mentioned in our prior article, the HQH fund’s strategy is higher risk compared to the other Tekla/abrdn funds, as it contains a large allocation to biotechnology stocks. As of March 31, 2023, the HQH fund had 62.1% invested in biotechnology companies and 17.9% invested in Pharmaceuticals (Figure 2).
Figure 2 – HQH sector allocation (HQH semi-annual report)
Furthermore, the HQH fund held $76.5 million in Level 3 assets (investments that have unobservable inputs, i.e. private investments) as of March 31, 2023, or 7.7% of total assets (Figure 3).
Figure 3 – HQH held a large weight in private investments (HQH semi-annual report)
Private investments are usually pre-IPO investments in companies that have high risk / high reward potential. When equity markets are hot, start-up companies go public and pre-IPO investors can reap multiples of their investment. However, when risk appetites are low and the IPO markets are closed, like they have been for the past 2 years, pre-IPO investments can also be written down as the company runs out of capital.
In general, this has translated into the HQH Fund having a weaker risk-adjusted returns profile compared to other health care funds (Figure 4).
Figure 4 – HQH has a weaker risk-adjusted return compared to peer healthcare funds (morninstar.com)
On the positive side, the HQH fund pays a managed distribution of 2% of trailing NAV. Over the past 12 months, this has translated into $1.60 / share in distributions or a 10.8% trailing distribution yield. Most recently, the fund declared a $0.38 / quarter distribution, which translates into a forward 10.2% yield (Figure 5).
Figure 5 – HQH pays a forward 10.2% yield (Seeking Alpha)
However, the HQH fund’s historical returns have been sub-par, with the HQH fund returning only 3.5% p.a. over the past 5 years and 5.6% p.a. over the past 10 to October 31, 2023 (Figure 6).
Figure 6 – HQH historical returns (morningstar.com)
This is insufficient to fund the HQH fund’s aggressive distribution yield. In fact, the HQH fund’s distribution is mostly funded from harvesting capital gains (Figure 7).
Figure 7 – HQH’s distribution is mostly funded from realized gains (HQH semi-annual report)
I believe the main reason for HQH’s poor returns the past few years has been the rise in interest rates and its detrimental impact on long-duration equity sectors like biotech.
Since peaking in early 2021, the biotechnology sector, as measured by the SPDR S&P Biotech ETF (XBI), has declined by over 60%, one of the worst drawdowns on record (Figure 8).
Figure 8 – XBI has suffered a 60% drawdown due to higher interest rates (Author created with price chart from stockcharts.com)
Biotechnology companies are typically bets on medicines and therapies years, if not decades, in the future, and hence their valuations are hypersensitive to the interest rates used to discount future cash flows.
Given my outlook for elevated interest rates and poor equity risk appetite, measured as the weakness in the ratio between the iShares Russell 2000 ETF (IWM) and the SPDR S&P 500 ETF Trust (SPY), I believe biotechnology stocks and the HQH fund may continue to struggle in the near-term (Figure 9).
Figure 9 – IWM / SPY ratio continues to plunge (Author created with price chart from stockcharts.com)
I will turn more constructive on the HQH fund if either of these two macro drivers change.
Recently, the Tekla Healthcare Investors fund changed its name to the abrdn Healthcare Investors fund, as the fund management company was acquired by abrdn. In the short-term, there should be no impact to the strategy and day-to-day management of the HQH fund, as the same team of investment professionals are managing the fund.
However, looking further out, the sale of Tekla Capital could be the manager’s way of ‘cashing out’, as he is close to retirement age. Investors should be mindful of potential management and strategy changes should Dr. Omstead chooses to retire.
With its heavy exposure to the biotechnology sector, the HQH fund’s returns have suffered in the past few years from the headwinds of higher interest rates and poor equity risk appetites. Until these factors change, I continue to advise caution on the HQH fund.
This content was originally published here.