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Healthcare and biotechnology have been star performers for 2013. The Health Care Sector ETF (XLV) is up 37.5% and iShares Nasdaq Biotechnology ETF (IBB) is up a whopping 60.3% for the last 52 weeks (SPY +27.4%). I, along with many market observers, consider that these sectors will continue to outperform in 2014, not by these incredible numbers of course, but they should outperform. Do you agree? If so, you might want to consider 2 closed end funds that are excellent choices to deliver outsized returns. I've talked about these a couple of months ago here. Today, I'll take closer look and add some thoughts on changes since the beginning of October.

The Funds

The two funds are from Tekla Capital Management. H&Q Healthcare Investors (HQH) and H&Q Life Sciences Investors (HQL) have been around for over 2 decades: HQH since April 1987, and HQL since May 1992. HQH holds $709M and HQL holds $308M total assets. Both have been managed by Daniel Omstead since September 2001. Dr. Omstead has extensive experience in the pharmaceutical industry and in private, development-stage, biotech companies.

The funds invest in healthcare and life sciences technologies including the expanding biotechnology fields. Each invests in publicly traded equities and, for up to 40% of their assets, in venture or restricted securities in both public and private companies. HQH invests in healthcare companies exclusively. HQL covers a broader spectrum of life science technologies expanding its focus to include agricultural and environmental biotech in addition to healthcare, which is its primary focus. As a consequence, HQL tends toward smaller holdings and is a little more volatile than HQH. These differences become evident deeper into their total portfolios as top holdings are essentially the same. The top holdings for each include Gilead Sciences (GILD), Regeneron Pharmaceuticals (REGN), Celgene (CELG), Biogen (BIIB), Alexion (ALXN), and other names familiar to the biotech investor.

Both funds have a managed distribution policy that delivers to shareholders quarterly returns at a rate of 2% of the funds' net assets. So, each distributes about 8% annually, the actual distribution yield varying somewhat as NAV and market prices vary. The funds caution that the managed distribution policy can result in a return of investor capital, but this has occurred only once (May, 2009) over the past 6 years. Unlike the typical managed-distribution, closed-end-fund, these funds are growth rather than income oriented. Thus, by default distributions - primarily comprising capital gains - are re-invested in additional shares, although a shareholder can opt to take the distribution in cash.

Performance

The chart below shows relative performance (market price) of HQH and HQL compared to the health care sector fund XLV and SPY, the broader market S&P500 ETF. These data give an idea of how well healthcare has done over the past year, and how strongly the CEFs have performed over at least 2 1/2 years. The chart covers price performance only; re-invested distributions are not considered. Thus, it greatly underestimates total return of the Tekla funds which are reinvesting (and compounding) a distribution of 2% of assets each quarter.

(click to enlarge)

A second interesting observation: Clearly, over the long term HQL generally turns in a comparable performance to HQH, but it has underperformed somewhat in the past few months. I'll add more on this point below because it holds a message for the interested investor.

What happens when we include those compounded distributions? This next chart compares growth of $10,000 invested in HQH, HQL, XLV and IBB, Nasdaq Biotechology ETF, for the 10 years ending 29 Nov 2013 with distributions for all funds reinvested.

(click to enlarge)

Through 2009 or so the 4 funds closely tracked one another with XLV and IBB generally outperforming a bit coming out of the recessionary period. Two years ago there began a marked upsurge in the 3 funds that emphasize biotechnology over the more generalized healthcare sector. HQH, HQL and IBB turned in more or less equivalent (and, I'll add, quite impressive) returns through mid-2013 when HQL began to lag.

The next two charts compare HQL's (blue mountain) and HQH's (red line) NAV and market prices for the past year. What we see here is that HQL's lagging performance over the past 6 months is largely a reflection of its market price. NAV values show much less gap between HQL and HQH. This observation follows up on the point made above on the recent underperformance of HQL relative to HQH. Again, we'll come back to this.

(click to enlarge)

Closed end funds find their market prices based on how investors perceive those funds. Since mid-2013 HQL has been trading at an increasing discount (currently at -3.80%) while HQH has moved into premium territory (currently at 1.76%). This is likely a reflection of investors' perceptions that pure healthcare biotech has better prospects going forward than the broader life-sciences biotech sector with agriculture and environment added to its holdings. I submit that this may be a questionable premise. It's true that agricultural and environmental biotechnology has lagged biomedical biotechnology over the past year, but it is not at all clear to me that this is a stable trend that will continue in 2014. One could argue that the health sciences arena is somewhat over extended at current prices and, by contrast, the broader life-sciences sector has more room to run over the coming year. It's not too great a stretch to see those broader ag and environmental biotech holdings as enhancing returns in this arena in the coming months.

Let's turn to a key feature of any closed end fund: Premiums vs. Discounts. Here's a snapshot of the recent price histories of these funds.

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I'm inclined to think that for an investor interested in biotechnology for 2014, HQL, at its current discount, presents a bit of a bargain compared to the alternatives. I base this on two points. First is its overall history of tracking its sibling fund too closely to justify a 500bps difference in their premium/discount. And second is its exposure to somewhat undervalued opportunities in the broader biotechnology sector, which, I submit, will serve it well in 2014.

Summary

Healthcare generally and biotechnology more specifically have been star performers over the recent past. For investors who consider that these fields will continue to outpace the broader market, an ETF like IBB (or for the more intrepid investor, BIB a 2x leveraged biotech ETF) offer appealing opportunities. The 2 closed-end funds I've discussed here should be considered as well. Both are unleveraged funds with strong track records in this field. Both offer exposure to private securities as well as publicly traded equities.

When I first discussed these funds two months ago, HQH was trading at a discount of about -3.75% and its sibling was comparably priced. HQH is now at 1.76% premium, and HQL retains the attractive discount (-3.8%) putting it about 260 bps below its 52 week average. In addition, it provides exposure to a somewhat broader spectrum of biotech opportunities than the strict healthcare options offered in other biotech funds. An investor looking to enter this space would have to give a priority to HQL at these prices. Someone already invested may even want to consider a swap of HQH for HQL.

Finally, let me add a note on taxes. Many closed end funds have tax-advantaged investment objectives. By contrast, the managed distribution policy of the Tekla Capital Management funds can have unwelcome tax consequences, so it may be prudent to hold these funds in a tax-deferred account where that's an option.

I remind readers that I have no professional expertise in equity analysis or tax matters. I am a private investor sharing my own research. Obviously, anything a reader finds interesting and worth pursuing in this article will require careful due diligence and full consideration of how the positions might fit his or her goals and objectives. And, of course, I welcome your thoughts and comments on this topic.

Source: 2 Biotech Funds You Should Consider Owning For 2014