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ETF Spotlight: Healthcare Leaders Income ETF
Michael Southern, CFA
Many investors understand the long-term thematic support for the healthcare sector; however, with a lot of short-term headline risk coming out of the United States (US), at 5i Research we are frequently asked via our Q&A service about sector companies. As funds go, we are commonly queried about the Healthcare Leaders Income ETF (HHL), and this will be the focus of our Monthly Fund Spotlight.
The fund’s investment objectives are to provide unit holders with (1) the opportunity for capital appreciation; (2) monthly cash distributions; and (3) lower overall volatility of returns than would otherwise be experienced by owning underlying positions directly. The fund is available in both CAD (HHL) and USD (HHL.U). The Fund originally commenced operations as a TSX listed closed-end fund on December 18, 2014 and converted into an exchange-traded fund on October 24, 2016.
How Much?
The first thing investors will notice about HHL is the 8.3% distribution yield. HHL targets a $0.0583 per unit distribution, paid monthly. How can this be when top names like Johnson & Johnson, Merck & Co. Inc. and Gilead Sciences all yield less than 3.0%? Writing options.
In order to generate additional returns, the fund will sell call options each month on underlying positions. With large-cap stocks that demonstrate minimal month-to-month volatility, this is not a bad thing. It allows the fund to sit back and collect the option premium. In falling equity markets, it can provide a bit of a cushion as well, but only as much as the option premium allows for.
Where covered call writing becomes less appealing is in appreciating equity markets. When stocks kick it into high gear, those who write options will see their portfolio underperform the broad market. This is because investors that bought the call option (HHL sells the option) will call away the stock from the fund. To maintain its exposures in such an environment, HHL would have to repurchase the called stock at a now higher price.
The volatility and high growth potential of the sector provides for excellent capital gains in 'good' periods; however, focusing on cash distributions limits this potential for the sake of income. In our opinion, we think capital gains should be emphasized over income for the average investor with a long-term time horizon.
Keeping What’s Yours
As per the fund’s webpage and tax information, 100% of the HHL distribution is taxed as return of capital (ROC). A ROC occurs when an investor receives back a portion of the original investment. The ROC payment is not considered a taxable event. There is no income or capital gains tax. However, ROC does have the affect of reducing your 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.
If the units are inside an RRSP/TFSA, there are no tax consequences to receiving part or all of the income as ROC. In a non-registered account, ROC would not be taxed in the year it is received, but the cost base of your units would be adjusted to reflect the payment. The results in a higher taxable capital gain when you ultimately sell the units.
Fund Performance
HHL completed its initial public offering (IPO) of units at a price of $10 per unit in December 2014. At a current market price of $8.4, the fund has lost money over its existence. Of course, this only considers the price component of returns and as we noted earlier, investors likely trade in HHL for the income aspect. Since its inception, the fund shows a total return of 2.6%. However, for a product that yields more than 8.0%, these returns would likely disappoint investors. It also emphasizes how dependent the fund is on the distribution, as the price component lags. Keep in mind this payout is a target only. The last three months have been good ones for the sector and the fund is up 9.3%.
Any investor considering a more active ETF approach should look to see how the strategy has performed compared to a low cost, passive approach. We can compare HHL to the BMO Equal Weight U.S. Health Care ETF (ZUH). Both are hedged to the CAD. HHL shows a 1-year and 2-year total return of 12.0% and 2.5%, respectively. Over the same time periods, ZUH reports a 16.0% and 3.0% return. The big difference here is that ZUH accomplished its return with little reliance on the distribution, currently yielding only 0.4%. Here, HHL appears to offer little advantage over a low cost, passive ETF for those investors who do not rely on the yield.
According to Morningstar data, HHL currently has a forward price-to-earnings ratio of 18.2 versus 21.3 for ZUH and 19.3 for Health Care Select Sector SPDR ETF (XLV), a sector benchmark ETF out of the US. Therefore, HHL may be an attractive way to enter the space and benefit from a cheaper valuation than more traditional routes. HHL does not trade at a significant premium/discount currently.
Underlying Holdings
The fund will invest in an equally weighted portfolio of equity securities of 20 health care issuers, whose underlying business includes, but is not limited to, the provision of health care goods and services, including manufacturing and distributing health care products, equipment, supplies and technologies, producing and marketing of pharmaceuticals and biotechnology products, and/or engaging in research and development that have a market capitalization of at least $5-billion (U.S.), and have options in respect of their equity securities listed on a recognized options exchange.
The funds positions are a ‘who’s who’ of global healthcare providers. We like the higher conviction approach the fund takes. For investors, this means each underlying position will be a meaningful contributor to overall performance and there is the possibility for higher returns if the manager demonstrates alpha in the space.
How a Tweet Could Hurt
It has been a wild ride for the sector over the last year, and even something as simple as a tweet has resulted in higher sector volatility. Remember Hilary Clinton’s tweet on drug price reform?
Recent headline news has not been in short supply and the sector is one that is subject to significant political risk. For example, the American Health Care Act (AHCA) — the first step in Republicans’ strategy to “repeal and replace” Obamacare — was recently debated in Congress. The bill, championed by Speaker Paul Ryan and backed by President Donald Trump, would be the first “prong” in what Republicans call a “three-prong strategy” to change the Affordable Care Act (known as Obamacare), passed in 2010. We now know that the man who promised to “immediately” repeal the Affordable Care Act did not repeal it at all, and the bill failed to pass. This serves as the most recent example of the day-to-day volatility investors must stomach when investing in the space, particular some of the higher growth industries such as biotech.
The Forest Through the Trees
Despite day-to-day swings, the outlook for the sector is promising. Encouraging industry trends including hopes of an aging population, expanding insurance coverage, growing middle class, an insatiable demand for new drugs, increased M&A activity, an accelerated pace of innovation and promising drug launches, will continue to fuel growth in the sector. However, with no shortage of bearish or ‘uncertain’ near-term sentiment, investors may want to consider staying on the sidelines for now.
Those long-term investors who wish to capitalize on the volatility and a recent slump in prices have many fund options available to them. While HHL has some positives, particular for the income investor, we think there are better ways to benefit from sector growth, and at this time, continue prefer low-cost, passive approaches like ZUH (CAD) or XLV (USD).
| ETF Details | |
| Ticker | HHL/HHL.US |
| Price (2017/03/27) | 8.40 |
| Management Fee | 0.85 |
| Annualized inception return | 2.55 |
| Inception date: | 2014/12/18 |
| Top 5 % | 25.00 |
| Top 10 % | 50.00 |
| Total holdings | 20.0 |
| Yield % | 8.33% |
| P/E | 18.2 |
| P/B | 3.2 |