Health-care stocks have emerged as market leaders in the third quarter, helping push major U.S. indexes to new highs.
One reason: Money managers are embracing the sector as a safety play, particularly after big technology stocks stumbled in September.
The S&P 500's health-care sector is the best performer of the index's 11 groups in the third quarter, up 13% and on pace for its strongest showing in more than five years. On a year-to-date basis, health-care stocks are trailing only the technology and consumer-discretionary sectors.
Hedge funds have built up their biggest position in health-care shares of the past five years. About 17% of their assets are in the sector, second only to shares of tech companies, according to Goldman Sachs Group Inc. data through June. Mutual-fund managers have also been shifting into health-care stocks, with many building outsize positions, according to Goldman's data.
And flows into health-care-focused mutual funds and exchange-traded funds, which are popular with retail investors, are at their strongest in three years, according to Morningstar Inc.
Rising interest in the stocks coincides with surging profits across the industry. Plus, the health-care needs of an aging population are expected to insulate the companies from a downturn, and investors searching for attractively valued stocks after a nine-year bull market in the U.S. have embraced the shares.
The sector's rally has been broad, with shares of pharmaceutical giants like Merck & Co. (MRK) and Pfizer Inc. (PFE), insurers including Humana Inc. (HUM) and UnitedHealth Group Inc. (UNH), and equipment suppliers like Abiomed Inc. (AMBD) and Align Technology Inc. (ALGN) all rising at least 20% in 2018.
"These stocks had been out of favor for a while," said Tom Hancock, head of focused equity at Grantham, Mayo, Van Otterloo & Co., the Boston-based money-management firm founded by famed investor Jeremy Grantham.
"But we've been trying to find stocks that aren't being inflated by this rising tide of economic good news," Mr. Hancock added, referring to the strong U.S. growth that has helped fuel a broad stock-market upswing in recent years. "When that tide recedes, we're looking for companies that will be OK in that environment."
Big tech stocks that have led much of this year's rally, including Amazon.com Inc. (AMZN), Google parent Alphabet Inc. (GOOG) (GOOGL) and Apple Inc. (AAPL), which each fell more than 3% in September. Investors have cut their exposure amid concerns about new regulations in the wake of Facebook Inc.'s (FB) data mishap.
At firms like GMO (GMO), investors have been trimming their technology holdings to help fund their shifts into health care. GMO's funds recently initiated a position in Merck, Mr. Hancock said, as the pharmaceutical giant has focused on further developing cancer-treatment drug Keytruda, which accounted for about 9% of the company's total revenue last year. Merck shares have surged 26% this year and 16% in the third quarter alone.
GMO funds, meanwhile, trimmed stakes in Alibaba Group Holding Ltd. (BABA) and Microsoft Corp. (MSFT) in the past six months, according to FactSet.
Similarly, hedge-fund manager Tudor Investment Corp. increased its stake in health insurer Aetna Inc. (AET) and initiated new positions in drugmakers Shire PLC (SHPG) and AbbVie Inc. (ABBV) all in the last six months, according to fund-holdings data compiled by FactSet. Millennium Management LLC, another hedge fund, added to its positions in medical-device makers Medtronic PLC (MDT) and Boston Scientific Corp (BSX).
Tudor declined to comment through a spokesman. Millennium didn't respond to a request for comment.
Some investors, though, question the timing of health care's sudden appeal, citing its bouts of volatility when political debates over how Americans pay for health care intensify. The sector will likely see another jolt should Republicans retain control of Congress in November's midterm elections and resume talks of a health-care overhaul, said Lewis Piantedosi, a vice president and portfolio manager for Eaton Vance Management, which has kept its allocation toward health-care stocks below its benchmark.
Still, the broader shift into health-care stocks suggests investors are eschewing risk after a long rally. Although the tax cut enacted in December led to an explosion in corporate profits that fueled the latest leg of the rally, Wall Street analysts and economists are increasingly convinced that the U.S. economy will start contracting as early as 2020.
Investors tend to view health-care stocks as a defensive investment because health insurers, pharmaceutical companies and medical-device makers usually hold up better in times of economic turbulence. That is because most medical expenses can't be put off in a recession, and economic swings don't typically curb the rollout of new drugs and devices. Valuations are also enticing, investors said, with health-care stocks in the S&P 500 (.SPX) trading in line with the broader S&P 500 at about 17 times future earnings, compared with 18 times for the tech sector and 23 times for consumer-discretionary companies, according to FactSet.
Biotech firms, however, are viewed as riskier and aren't getting nearly as much attention from big money managers, some investors said, because those stocks can move dramatically based on drug approvals. Biotech shares in the S&P 500 aren't seeing the same bump as pharmaceutical giants, insurers and medical suppliers.
"Not to say it can't continue, but we're in the longest bull market ever," said Matthew Watson, a portfolio manager and assistant vice president at James Advantage Funds, a mutual-fund manager that has boosted its positions in health-insurer Anthem Inc. and drugmaker Pfizer. "So from a risk standpoint, getting into health-care stocks, which tends to be defensive, makes sense for us too."
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