THW CEF: upside trade-off for yield

Viorika

I am constantly on the lookout for high yielding investments and funds, and have recently written about the Pimco Dynamic Income Fund (PDI) and the Simplify Volatility Premium ETF (SVOL). This article reviews the merits of the Tekla World Healthcare Fund (NYSE: THW).

Although I find the current payout yield of 9% attractive, I would personally stay away from the Tekla World Healthcare Fund. As a sector fund, its total return is lower than that of its peers such as the XLV ETF. The strategies employed by THW to generate income may limit upsides while exacerbating downsides.

Fund Facts

The Tekla World Healthcare Fund is a sector-focused closed-end fund (“CEF”) that invests primarily in the healthcare sector with $580 million in net assets. The fund seeks to generate current income and long-term capital appreciation through investment in equity and debt securities of companies active in the healthcare sector.

Strategy

The Tekla World Healthcare Fund employs a combination of growth and income investment strategies to achieve its mandate. It invests in all health sub-sectors (pharma, services, medical devices, life sciences, biotechnology, etc.) and in the capital structure of a company. THW invests at least 40% of the fund in non-US companies or companies with significant non-US revenues.

Some of the strategies employed by the Tekla team are to invest up to 20% of assets under management in non-convertible debt securities of companies in the healthcare sector, up to 20% of assets under management in REITs in the health and up to 30% of assets managed in convertible securities (warrants or convertible debt). The Fund may also invest a portion of its assets in restricted securities (ie private placements). To generate additional income, the Tekla World Healthcare Fund also writes (or sells) call options on a portion of the portfolio (usually less than 20% of assets under management). Finally, the fund can use up to 20% leverage to enhance returns.

Management team

THW is led by Dr. Daniel Omstead, former President and CEO of Reprogenesis, Inc., a development-stage biotechnology company that merged with Curis, Inc. (CRIS) in 2000. Prior to Reprogenesis, Dr. Omstead was senior vice president of R&D for cytotherapy. Dr. Omstead also has research experience at Merck and Johnson & Johnson. In addition to Dr. Omstead, THW’s investment team includes two MDs and four PhDs (Figure 1).

THW Investment Team

Figure 1 – THW Investment Team (THW file)

Dividend and yield

THW is a high yield fund, with a current yield of 9%, based on a monthly distribution of $0.1167/sh and a current unit price of $15.52. Impressively, the fund has paid the same distribution of $0.1167/sh since it began paying distributions in October 2015.

However, if we take a close look at the dividend, only 1/3 of the distribution comes from net investment income, according to its latest release (Figure 2). In past disclosures, repayment of principal or other sources has reached 100%.

broadcast source

Figure 2 – The distribution is not covered by the net investment income (THW Section 19(a) Notice)

Composition of the portfolio

The Tekla World Healthcare Fund offers a fairly comprehensive summary of its holdings on its website. As of June 30, 2022, the top ten holdings of the fund are shown in Figure 3 and represent 43% of the fund. In terms of sector allocation, we can see that 41% of assets under management are allocated to pharmaceuticals, 17% to service providers, 12% to biotechnologies, 12% to healthcare equipment and supplies and 8% to medical devices and life science tools. As of June 30, 2022, the fund has $615 million in assets under management and $120 million in debt, for a leverage ratio of 19.5%.

composition of the portfolio

Figure 3 – Composition of the THW portfolio (THW website)

Fund returns

On an absolute basis, the fund’s returns have been decent with an average 3-year and 5-year return of 8.5% and 7.0% per year respectively (Figure 4).

Returns THW

Figure 4 – THW Returns (THW website)

However, relative to its peers (closed-end healthcare funds as defined by Morningstar), the fund is generally in the 2nd or 3rd quartile (Figure 5). It has also generally underperformed the Morningstar US Health Total Return Index.

THW comes back against its peers

Figure 5 – THW Returns vs. Peers (morningstar.com)

Additionally, we can compare the Tekla World Healthcare Fund to the Health Care Select Sector SPDR ETF, which achieved 15.3% and 12.5% ​​annualized returns over 3 and 5 years (Figure 5). (Note dates are not exactly comparable, as THW returns are as of June 30, 2022).

XLV Returns

Figure 6 – XLV Returns (ssga.com)

When we consider that the fund has historically paid out $1.40 per year in distributions with current yields ranging between 8% (price peaked at $17.92 in early 2021) and 16% (price bottomed of $8.76 during the COVID-19 pandemic), it appears that most historical returns have taken the form of distributions. This is confirmed by the price chart, which has not shown much capital appreciation in the 7 years since the fund began operations.

THW price chart excludes dividends

Figure 7 – THW price chart excluding dividends (stockcharts.com)

Costs

The management fees for the Tekla World Healthcare Fund are quite high, at 1% annualized of the fund’s average daily net asset value. All in, the total spend is 1.74%. For comparison, the XLV ETF has a net expense ratio of 0.1%.

THW fees

Figure 8 – THW Charges (morningstar.com)

Investors should look beyond current income and total return

THW looks attractive to investors looking for current income, with nearly 7 years of uninterrupted distributions of $1.40 per year and a current distribution yield of 9%. However, I think investors should look beyond current yield and consider total returns. Based on this, investors might be better off investing in the XLV ETF at a lower cost.

For example, suppose investors invested in THW on December 31, 2015 at $15.83 per share. After investing in the fund for nearly 7 years, THW’s price on August 8, 2022 was $15.20. So, on a price basis, investors lost 3.8%. THW paid cumulative distributions of $9.33 over the 7 years, a return of 59%. However, if investors had purchased XLV on the same date, they would have realized a cumulative return of 83% in price and a cumulative return of 14% in distributions (Figure 8).

In other words, investors could have invested in XLV and monetized a portion of their portfolio on a monthly basis to mimic THW’s cash flow and come out on top.

Total return THW and XLV

Figure 9 – Total return THW and XLV (Author created with price data from stockcharts.com)

THW Strategies Trade Upside for Yield

I believe the main reason for THW’s underperformance is the trade-off the manager has to make to generate a high current return. Recall in the strategy section above, we mentioned that THW writes covered calls to generate current income. This means that in general, in rising markets, THW gives up some of the “upside” of its portfolio.

For example, in 2020 and 2021, the Morningstar US Health Total Return Index returned 17.4% and 21.0% respectively, but THW only returned 9.6% and 16.9% respectively (based on net asset value).

However, the downside capture may be exacerbated by THW leverage. The THW returned -15.0% in 2016 when the index was down 3.4%, and the THW returned -1.8% in 2018 when the index was up 5.9%.

Main risks

The biggest risk for a high yield fund like THW is a potential reduction in distribution. From Figure 2 above, we know that the majority of the distribution comes from return of capital or other sources, making it potentially less sustainable. To management’s credit, the distribution source from return of capital and other sources has reached 100% in previous months, which has not prevented the fund from paying its distribution of $1.40 per year .

Another risk for the fund is its sector orientation. Since healthcare is generally a defensive sector, this risk is somewhat mitigated. However, this exposes the fund to a unique sector risk, for example, possible healthcare reform.

Finally, the fund uses moderate leverage. Leverage can enhance returns both positively and negatively.

Conclusion

In conclusion, although I find the current payout yield of 9% attractive, I would personally stay away from the Tekla World Healthcare Fund. As a sector fund, its total return is lower than that of its peers such as the XLV ETF. The strategies employed by THW to generate income may limit upsides while exacerbating downsides.

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