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A look at affordable health care ETFs

  • By Roger Nusbaum,
  • TheStreet.com
  • – 10/24/2013
  • Health Care & Wellness
  • Investing in ETFs
  • Exchange-Traded Funds
  • Health Care Sector
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NEW YORK — The health care sector has been ground zero in the ongoing ideological battle that shut down the U.S. government this month. Regardless of anyone's politics, the health care sector will become an increasingly important part of the market as global demographics provide a positive catalyst while domestic politics create a negative catalyst or at the very least create uncertainty.

The more than 70 million baby boomers are, of course, moving into retirement, which provides the expectation of needing more medical attention. Other economically developed countries also have aging populations and while emerging markets tend to have younger populations, increased economic prosperity in those countries should mean more demand for advanced health care options.

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Investors who agree on a future of increased importance for the sector but who do not want to get blindsided by picking "losers" in how the industry evolves under the Affordable Care Act can of course consider exchange traded funds as a solution.

Index Universe tracks 24 funds in the sector excluding levered and inverse funds. The simplest exposure is the broadest exposure through a fund like the Health Care Select Sector SPDR (XLV) or the Vanguard Health Care ETF (VHT).

Funds like Health Care Select Sector SPDR and Vanguard Health Care ETF are emotionally easy to own because they are dominated by familiar mega cap stocks like Johnson & Johnson (JNJ) and Pfizer (PFE). But they also have decent exposure to the growth potential of biotechnology. These are market cap weighted funds so biotech giants like Gilead (GILD) and Amgen (AMGN) are well represented in the funds. Biotech makes up close to 20% of both funds.

Of course, for anyone wanting to narrowly focus on biotech there are several funds including the iShares Nasdaq Biotechnology ETF (IBB) and SPDR S&P Biotech ETF (XBI). From 2009 low biotech has outperformed the broader sector funds and that is likely to continue as the current Fed-induced melt-up looks poised to keep rolling on.

Health Care Select Sector SPDR, Vanguard Health Care ETF and iShares Nasdaq Biotechnology ETF have a combined $13 billion in assets out of the $24 billion invested in the sector but those three miss out on two important groups of funds.

Missing from the big three is foreign exposure. The largest ETF with foreign exposure is the iShares Global Healthcare ETF (IXJ) with $907 million in assets. The United States is the largest country in the fund at 61% with Switzerland and the United Kingdom also featuring prominently. iShares Global Healthcare ETF offers access to companies that includes Novartis (NVS) and Glaxosmithkline (GSK), which are not in the domestic funds.

In the five years leading up to the 2007 peak iShares Global Healthcare ETF outperformed Health Care Select Sector SPDR by 11 percentage points. The last few years have favored domestic exposure but when foreign rotates back into favor again then iShares Global Healthcare ETF should be the better hold.

The other often overlooked segment includes various rules-based sector funds like the PowerShares Dynamic Healthcare (PTH), which is constructed based on price momentum, earnings momentum and other qualitative factors, the First Trust Health Care Alphadex (FXH) built with proprietary growth and value factors, or the Guggenheim S&P Equal Weight Health Care (RYH).

Since the 2009 low, PowerShares Dynamic Healthcare is up 190%, FXH is up 257% and Guggenheim S&P Equal Weight Health Care is up 198% compared to 134% for Health Care Select Sector SPDR. In past articles I've discussed the need for ETF investors, like stock investors, to do their homework, which includes funds like these that are a little off the beaten path but have very long track records of outperformance.

There is one serious gap in all of the above mentioned ETFs, which is their yields are typically less than the 2% of the S&P 500 (.SPX). To capture any meaningful yield an investor will need to consider individual stocks. Yield in the sector comes mostly from the mega cap names like Johnson & Johnson, Pfizer, Novartis and GlaxoSmithKline, which yield 2.89%, 3.16% 3.22%, and 4.65% respectively.

A portfolio that includes a pairing of one of the rules-based funds with a higher yielding mega cap stock will not be duplicative because the higher yielding mega caps don't feature prominently in the rules-based funds.

At the time of publication the author held no positions in any of the stocks mentioned.

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