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ETF Specialist

Health-Care Funds: Hale and Hearty

Health-care stocks' performance has amazed. Here's an outlook for the sector, along with some active and passive options for investors.

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The health-care sector's returns have continued to be very potent. More than almost any other corner of the U.S. equity market, health-care stocks have dazzled in recent years, including the nearly five years since President Barack Obama signed his health-care bill into law.

However, the health sector's performance has impressed over both longer and shorter time periods as well. For the decade ended March 6, 2015, the health-care sector category posted average annualized returns of 13.8%, or more than 6 percentage points above the S&P 500's 7.5% annualized return during that same interval. Over shorter time frames, the sector also has performed very well, returning 21.3% annualized during the past five years, 30.2% during the past three years, 24.0% during the past year, and 7.0% year to date. In every time period, the health-care Morningstar Category average has far outpaced the broad U.S. large-cap benchmark.

It's not just the S&P 500 that the health-care sector has bested. The sector also has outperformed all other U.S. equity sectors during every period studied. And health care also has topped broad large-growth funds as well. Year to date, the large-growth category's 3.5% average return is exactly half that of the health-care sector, and the health-care sector's 24% return during the past year trounces large growth's 9.9% average return. The story isn't much different when looking at longer periods, as large growth's average annualized returns of 17.1% over three years, 14.4% over five years, and 8.2% over a decade all fall considerably short of the health-care sector's stellar returns.

A Perfect (Positive) Storm
Why has the health-care sector done so well? Some of it relates to low valuations in 2009 and 2010 of pharmaceutical stocks, which make up anywhere from 40% to 45% of the sector. At that time, investors worried about the impact of U.S. health-care reform and a wave of major patent losses that peaked in 2012.

But drug companies adapted to patent headwinds far better than investors had expected. In addition, drug and biotech firms have enjoyed an improved growth outlook after payers decided to reimburse less for slight enhancements to already-approved drugs. That change prompted pharmaceutical firms to shift their pipeline focus toward unmet medical needs such as cancer and hepatitis C. Now, those new drugs are coming to market, and pharmaceutical firms are seeing the fruits of these innovations. A favorable regulatory environment also has helped matters, resulting in key drug approvals.

On top of all that, the health-care sector has been awash in merger and acquisition activity, which has lifted valuations. Pharmaceutical and device firms continue to merge in an effort to create scale and focus on key strategic areas. Some firms are pushing pairings with foreign players as a way to deploy trapped overseas cash and to make acquisitions abroad in order to reduce the acquisitor's tax rate. The biotechnology sector also has been the target of acquisitions by large pharma firms that have sought to grow externally and add research and development to their pipelines.

A Well-Valued Sector
After years of strong gains, Morningstar's equity analysts now consider the health-care sector to be slightly overvalued in aggregate, although there are pockets of value, including the pharmacy benefit manager subsector. As a result, the analysts suggest investors be selective in the sector.

Looking ahead, the health-care sector could post larger returns if patients use more health-care services than expected, which would be driven mostly by U.S. health-care reform. With mandated health-care insurance now in the U.S. and expanded government insurance, more people are seeking out treatment. This is a net positive for most health-care firms. Longer term, Morningstar's equity analysts suggest that investors anticipate various sector headwinds but nonetheless have settled on a positive long-term outlook for the health-care sector.

Broad Passively Managed ETFs for Health-Care Investors
For investors looking for exposure to a basket of health-care stocks, two very large and liquid, broad, passively managed health-care exchange-traded funds are available to investors at a low cost:  Health Care Select Sector SPDR (XLV) and  Vanguard Health Care (VHT). The two ETFs charge 0.15% and 0.12%, respectively. Both funds seek to replicate broad indexes of large U.S. health-care stocks, holding pharmaceutical firms, biotech companies, health-care providers, health-care equipment makers, and life sciences firms. VHT holds 323 health-care stocks, while XLV is a much more concentrated portfolio representing just 56 companies. VHT also dips further down the market-cap ladder than XLV, devoting 14% of assets to mid-cap firms and 7% of assets to small-cap companies. XLV, by contrast, invests just 7% of assets in mid-cap health players and has no small-cap allocation.

Two other broad and passively managed health-care ETFs have less appeal.  IShares U.S. Healthcare (IYH) holds 108 health-care names but charges a much higher 0.43% expense ratio. Investors in IYH can gain very similar exposure for a fraction of the cost by holding XLV or VHT. Meanwhile, Fidelity MSCI Health Care ETF (FHLC), which holds about 320 stocks, charges a rock-bottom 0.12% and has style and subsector weightings that very much resemble those found in the Vanguard ETF. However, FHLC is a less liquid fund than VHT, so VHT offers more flexibility, particularly for investors planning on doing frequent trading or for those looking for listed options.

The Best Actively Managed Open-End Health Funds
For investors seeking active stock-picking in the sector, several open-end mutual funds devoted to health care have delivered outstanding performance in recent years.

Easily the largest actively managed health-sector mutual fund is  Vanguard Health Care (VGHAX), which has earned a Morningstar Analyst Rating of Gold. It has returned 24.0%, 30.2%, and 21.3% over the trailing one-, three-, and five-year periods ended March 6, 2015. The fund has roughly matched its category's performance during the past year but has lagged the category in the three- and five-year time frames, largely because of the long-standing way the fund is managed. Lead manager Jean Hynes, who took the helm in 2012 after serving as a named manager on the fund since 2008, has continued Vanguard Health Care's tradition of offering investors solid downside protection. As a result, the fund has done a fine job of playing defense, losing less than its typical peers during downdrafts but similarly capturing less than its typical peer's gains during more-recent rising markets. In addition, Vanguard Health Care's stake in biotech--a subsector that has produced superb returns--has been lighter than its typical health-care category peer during the past several years.

Meanwhile, T. Rowe Price Health Sciences (PRHSX) has significantly outperformed the health-care category in recent periods. Year to date, the fund has returned more than 12% versus the category's nearly 9% return, and in the one-year period ended March 6, 2015, the fund returned more than 32% versus the category's 24% return. The fund hasn't lost a step with the departure of longtime manager Kris Jenner, who exited two years ago. Lead manager Taymour Tamaddon, a longtime analyst on the fund who succeeded Jenner in February 2013, maintains a smaller-cap, growth-oriented bent and also keeps a larger stake in biotechnology (currently 33% of the fund) than the 23% biotech weighting in the MSCI U.S. Investable Health Care 25/50 Index benchmark. The fund also has a smaller allocation to the pharmaceutical industry than the MSCI index. Investors who stuck with T. Rowe Price Health Sciences through the transition from Jenner to Tamaddon have enjoyed terrific annualized returns of 38.5% during the past three years, 29.0% during the past five years, and 19.1% during the past decade.

Fidelity Select Health Care Portfolio (FSPHX) has outperformed its category over the past one-, three-, five-, and 10-year periods, returning 25.8%, 37.3%, 26.8%, and 15.6%, respectively. Lead manager Eddie Yoon also has favored a higher stake in biotech firms than peers and the MSCI U.S. Investable Health Care 25/50 Index, along with a lower weighting in pharmaceutical firms.

All three of the above funds have posted investor returns that have only slightly trailed the funds' total returns over both short- and longer-term periods.


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Robert Goldsborough does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.