Bet on Biotech

Health care plays are compelling investments not just because of their defensive properties in a volatile market, but also because of their demographic destiny. As millions of Baby Boomers age, health care firms should benefit from boomers’ outsize demand.

For those investors who’d like to round out their allocation to the health care sector with a niche offering, H&Q Life Sciences Investors (NYSE: HQL) may be the right prescription.

However, don’t let the closed-end fund’s (CEF) enviable 9.8 percent distribution rate lull you into assuming such income makes H&Q Life Sciences suitable as a core portfolio holding. This fund pays an enviable quarterly distribution out of its long-term capital gains, but its orientation toward smaller biotechnology firms means that investors should only consider this relatively risky fund after they’ve established positions in steadier fare.

Although CEFs have many similarities to mutual funds and exchange-traded funds (ETF), they are actually distinct from both. CEFs have actively managed portfolios like most mutual funds, but they trade on exchanges like ETFs. Unlike mutual funds, CEFs are permitted to use leverage, but fortunately this fund does not use leverage to enhance its returns.

While the structure of ETFs enables them to track their net asset values (NAV) closely, CEFs can trade at prices that deviate widely from their NAVs. In this case, H&Q Life Sciences trades at nearly an 11 percent discount to its NAV. Many CEFs trade at persistent discounts to their NAVs. However, such discounts allow value-conscious investors to purchase assets cheaply relative to their market value.

Additionally, CEFs often make efforts to reduce these discounts for their shareholders. Earlier this year, the fund made a tender offer to buy investors’ shares at 98 percent of its NAV. And in July, the fund announced a one-year program to buy back 12 percent of its outstanding shares.

The fund’s portfolio is heavily weighted toward small- and mid-cap biotech stocks, with a substantial 20 percent allocation to micro-cap stocks—stocks that have market capitalizations below $300 million. But one of the chief attractions of this fund’s portfolio is its venture capital sleeve. The fund’s charter allows it to invest up to 40 percent of its portfolio in the venture financing it provides to both public and private firms.

At the moment, however, this sleeve comprises a relatively modest 12 percent of total assets. Even so, potential investors should be aware that these are illiquid investments whose risk does offer high rewards, but can occasionally result in total wipeouts via bankruptcy. Still, the fund beat the market by a wide margin over the trailing 15-year period.

Investors should also know that the fund can suspend its distribution as the result of a protracted downturn, as it did for eight months from 2009-10. Prior to that, the fund paid distributions for 35 consecutive quarters, so management is committed to a distribution even if extraordinary circumstances occasionally force its suspension.

Finally, CEFs have lower average trading volumes than equities, so it’s best to use limits when buying or selling shares of H&Q Life Sciences.

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