ETFs for a Health-Care Play

After a lengthy period of relatively calm, investors have gotten a reminder that stocks do indeed move up and down--sometimes dramatically. Some investors have moved to damp the volatility of their equity portfolios by allocating more assets to traditionally defensive sectors, such as health care. Health care is a basic need, so demand for health-related products and services typically holds up during economic downturns. For the most part, the data support this conventional wisdom. Growth in health-care spending and GDP growth have been uncorrelated over time, according to Morningstar stock analysts.

But we think the appeal of this sector goes beyond its defensive reputation. The biggest health-care companies, particularly big pharmaceutical firms, possess significant competitive advantages that allow them to produce above-average returns on capital and ample cash flows. Industry leaders  Pfizer (PFE) and  Johnson & Johnson (JNJ) provide the most dramatic examples. Over the past few years, each company has generated annual cash flows between $9 billion and $12 billion. To top it off, Pfizer is sitting on more than $20 billion in cash, some of which it returns to investors through a fat dividend payout.

Our equity analysts have some ideas for individual health-care stock picks, including those mentioned above. However, exchange-traded funds can also be a great way to invest in the sector, particularly for those seeking to tone down risk. Many health-care stocks are exposed to company-specific risks that are difficult, if not impossible, to predict, such as litigation risk or regulatory failures. By investing in a basket of stocks, most of these company-specific issues can be diversified away.

The table below includes health-care ETFs where our equity coverage extends to at least 80% of the fund's assets.

Heath-Care ETFs
	Coverage Ratio (%)	P/FV Ratio	% Wide Moat Stocks	% Above Average Business Risk	# of Stock Holdings	% Assets in Top 10 Holdings	Expense Ratio (%)
Biotech HOLDRs	100	0.88	71.20	24.30	15	98.38	NA*
First Trust AMEX Biotech Index (FBT)	100	1.01	19.70	72.50	20	57.88	0.60
First Trust Health Care AlphaDEX (FXH)	93.7	0.97	14.00	33.10	71	26.72	0.70
Health Care Select Sector SPDR (XLV)	99.3	0.87	62.40	8.30	51	57.83	0.24
HealthShares Cardiology	82.5	0.84	0.00	60.60	22	64.03	0.79
iShares DJ US Healthcare (IYH)	97.6	0.88	57.70	14.00	143	50.77	0.48
iShares DJ US Healthcare Provider (IHF)	90	1.00	0.00	33.40	49	67.03	0.48
iSharesDJ US Medical Devices (IHI)	85.5	0.91	32.00	13.60	41	58.26	0.48
iShares DJ US Pharmaceuticals (IHE)	94	0.85	52.00	26.00	37	56.81	0.48
iShares Nasdaq Biotechnology (IBB)	83.1	0.98	0.00	51.10	166	44.84	0.48
Pharmaceutical HOLDRs	99.3	0.83	90.00	3.20	19	93.07	NA*
PowerShares Dynamic Healthcare (PTH)	82.6	0.99	11.00	29.30	60	25.26	0.71
PowerShares Dyn Healthcare Svcs	82.6	1.00	5.40	38.40	30	46.10	0.70
PowerShares Dynamic Pharma (PJP)	94.1	0.90	49.90	27.90	30	46.05	0.63
PowerShares FTSE RAFI Hlth Care	99.1	0.86	67.40	8.30	64	65.14	0.75
Rydex S&P Equal Weight Health Care (RYH)	98	0.89	34.30	16.10	51	20.11	0.50
SPDR S&P Biotech (XBI)	85.5	0.97	15.00	67.90	29	35.20	0.35
SPDR S&P Pharmaceuticals (XPH)	90.6	0.83	37.80	46.80	22	46.21	0.35
Vanguard Health Care ETF (VHT)	93.9	0.89	52.90	13.50	266	47.69	0.22
Data as of 2-5-08. * HOLDRs charge an $0.08 per share annual custody fee.

As you can see, some of the highest-quality portfolios are also the cheapest. Those ETFs with the largest allocation to wide-moat stocks also sport some of the lowest price/fair value ratios. That's largely because many big pharmaceutical firms, which soak up a lot of the assets in these ETFs, look cheap to our equity analysts.

Granted, big pharma hasn't gotten a lot of love from the market lately. Most of these stocks have badly underperformed in recent years. Investors have had a number of issues to fret over including high-profile judicial awards and Phase III regulatory failures. In addition, big blockbuster drugs continue to roll off patent, leaving these companies vulnerable to competition from generics.

Although patent expirations are a real concern, our health-care analysts think the market is focusing too much on past problems and not giving the industry enough credit for its long-term potential. Many firms have solid pipelines, and some have redirected their R&D efforts to niche diseases where there is less competition, more pricing power, and thus enhanced profitability. Meanwhile, most big pharma companies boast solid balance sheets and continue to churn out scads of cash. The market's failure to fully recognize these positives is giving investors a chance to scoop up these industry giants at bargain basement valuations.

ETF Picks
ETF investors have two choices for broad and cheap exposure to health-care stocks--Vanguard Health Care ETF (VHT) and Health Care Select Sector SPDR (XLV). But even though their holdings range from drugmakers to medical equipment manufacturers to biotech firms, big pharma dominates both portfolios. The big three--Johnson & Johnson, Pfizer, and  Merck (MRK)--consume 30% of the SPDR's assets and almost a quarter of the Vanguard portfolio. Consequently, the performance of these industry behemoths has a big impact on the returns of these funds. The returns of both portfolios have been highly correlated over time, and we'd expect them to deliver similar long-term results.

Sure, you could go with an ETF that focuses exclusively on pharma stocks, such as Pharmaceutical HOLDRs , iShares Dow Jones US Pharmaceuticals (IHE), SPDR S&P Pharmaceuticals (XPH). True, these funds look most compelling from a valuation perspective. However, all three are concentrated portfolios. Pharmaceutical HOLDRs is the most extreme. Its portfolio includes just 19 stocks, and Pfizer, Merck, and Johnson & Johnson combined soak up 54% of its assets. Although iShares Dow Jones US Pharmaceutical and SPDR S&P Pharmaceutical are less top-heavy, they span only 37 and 22 holdings, respectively. Moreover, the latter two funds include smaller firms that court more business risk. At these valuations, we think investors will be adequately compensated for those risks, but it's a more aggressive play, and it's certainly not for those who would rather keep volatility to a minimum.

 

		ETFInvestor Newsletter
	Let our new newsletter, Morningstar ETFInvestor, help you navigate the exciting and new world of exchange-traded funds. Each issue includes recommendations for commonsense ETF investing,		ETF spotlights, and critical data on 150 top ETFs. This one-year subscription consists of 12 monthly issues. Learn more.
	$149.00 for 12 Print Issues		$139 for 12 PDF Issues