If you are an income-focused contrarian investor, closed-end funds (“CEFs”) can be a corner of the market ripe with interesting opportunities. This article focuses on an attractive high-income CEF in the healthcare sector—a sector with plenty of long-term growth opportunities, but currently somewhat out of favor considering it has underperformed other sectors so far this year.
Overview: Tekla World Healthcare (THW)
Tekla World Healthcare Fund ("THW") is a closed-end fund that invests primarily in the healthcare industry and it offers a big yield (currently greater that 10%, paid monthly). The Fund's objective is to seek current income and long-term capital appreciation through investment in companies engaged in the healthcare industry, including equity securities and debt securities.
For some perspective, here is a look at the fund’s sub-sector and security type allocations.
What Are the Advantages of Investing via a CEF?
Before getting into more of the specifics of the Tekla World Healthcare Fund, it’s worthwhile to briefly consider some of the benefits of investing in a closed-end fund.
For starters, CEF’s often offer high yields (more on the “nuts and bolts” of THW’s distribution payments later), which can be very attractive if you’re seeking income. Another advantage is that CEFs offer some instant diversification; they hold a basket of securities (even if they are concentrated in specific industry) which is less risky that holding only one or two stocks. They also offer active management teams. And very importantly, CEF’s can trade at very attractive prices considering they’re often bought and sold at significant discounts to the value of the securities they hold (we’ll get more into THW’s specific discount later in this report).
Why is the Healthcare Sector Currently Attractive?
The Tekla World Healthcare Fund invests primarily in healthcare securities, so it is worthwhile to consider the attractiveness of this sector. As we saw earlier, the overwhelming majority of this fund’s holdings are equity securities related to healthcare. For example, you can see the fund’s top holdings in the following table.
And as we can see in the next table (below), healthcare stocks have been underperforming other market sectors so far this year (the table is sorted by year-to-date total returns, and the sectors are highlighted in light blue).
Healthcare tends to be a relatively stable and moderate volatility sector (its beta is just below 1 in the table above). And healthcare had been posting strong returns over the last 3 and 5 years, until its recent cool down. Healthcare has strong long-term dynamics on its side as healthcare needs continue to grow, and if simply from a contrarian standpoint, it’s a good sector to consider investing in now; and the Tekla World Healthcare Fund is a compelling way to do it because the price is discounted and the yield is high.
THW’s Current Discount to NAV Is Attractive:
As we mentioned earlier, one of the attractive qualities about CEFs is that they can trade at a significant discount to the value of the assets they hold. This creates the potential for price gains if the discount spread narrows, but even if a CEFs discount never disappears (even if it trades at a discount to NAV forever), it affords investors a chance to buy yield (income) at discounted prices (i.e. below the market rate).
Here is a look at THW’s current and historical discount to net asset value.
Leverage (Borrowed Money):
Depending on the strategy, many CEFs borrow money (i.e. use leverage). This can be particularly attractive in the good times because it can magnify returns. However, it can also be a risk because it can magnify losses when the market goes down. For perspective, here is the current leverage ratio (among other metrics) for healthcare sector CEFs in Morningstar’s CEF Quickrank database.
Keep in mind the leverage is not free (there is an interest charge to borrowing money). And this cost may rise as interest rates keep rising. The good news is there are regulatory limits to the amount of leverage CEFs can use. For example, it’s rare to see a bond fund go over 40% or an equity fund go over 30% (although they often maintain levels very close to these limits). Some investors prefer leverage while others prefer none. Also, funds that use leverage get it at low institutional rates (i.e. rates lower than the average Joe can get in his personal account).
Expense Ratios and Management Fees:
Expense ratios and management fees are another important consideration for CEF investors. If you are simply looking for exposure to the healthcare sector, a healthcare ETF (such as XLV) is a cheaper way to do that. However, that ETF lacks the active management team, the high yield, the potential for a big discount to NAVs (ETFs are open-end funds, therefore there are mechanisms to directly eliminate discounts and premiums), and ETFs generally don’t use leverage (there are some exceptions). Keep in mind if a CEF does use leverage (borrowed money) those costs are often rolled up into the total expense ratio. In the case of the Tekla World Healthcare fund, the total expense ratio is 2.28% per year, but that includes the cost of the leverage (borrowed money) that the fund uses. This seems like a high fee—and it is, but its not that high when you consider 50% or more is simply the cost of borrowing.
If you like high yield (i.e. regular income payments) the annual yield of THW is 10.9%, and it is paid monthly (most CEFs pay quarterly). The objective of the fund is to seek current income and long-term capital appreciation, and its policy is to distribute to its shareholders substantially all of its investment company taxable income, if any, for each year.
Here is a look at the historical distribution breakdown by type.
This information is important because it’s taxed differently (i.e. long-term rates, versus short-term rates, and income including qualified and non-qualified dividends). Regarding “Return of Capital,” this too impacts your taxes because you can end up having a bigger capital gain than you expected if/when you do eventually sell. Here is what Investopedia has to say about return of capital:
“Return of capital (ROC) is a payment, or return, received from an investment that is not considered a taxable event and is not taxed as income. Instead, return of capital occurs when an investor receives a portion of his original investment, and these payments are not considered income or capital gains from the investment. Note that a return of capital reduces an investor's adjusted cost basis. Once the stock's adjusted cost basis has been reduced to zero, any subsequent return will be taxable as a capital gain.”
We’d be remiss not to explicitly mention risks to the fund. For example, because it’s concentrated in the healthcare sector, the fund will likely perform poorly if the sector does. Also, the leverage can make things particularly good in the good times and particularly bad in the bad times (note: markets generally go up in the long-term, so the conservative leverage will likely work significantly to your advantage). Further still, management fees will be a drag on performance (however, in exchange for the management fee, you do get an attractive actively managed investment). And also, the discount to NAV can get wider at times, and often does. These are all things you should keep in mind if you’re going to invest in this closed-end fund.
If you are an income-focused investor, the Tekla World Healthcare Fund (THW) is attractive because it offers a big distribution yield (10.9% annually, paid monthly), it trades at an attractive discount to its net asset value, and long-term demand in the healthcare sector is compelling, especially from a contrarian standpoint as the sector has recently cooled off compared to other market sectors and compared to its own history. Further still, the active management team and prudent use of leverage are compelling, in our view. If you’re looking for some high monthly income payments, this fund is worth considering.
Note: We are currently long THW in our Blue Harbinger Income Equity Portfolio.