Health Care on the Defensive

One of our favorite sector funds is  iShares S&P Global Healthcare (IXJ). This exchange-traded fund offers investors exposure to a portfolio of some of the finest health-care companies in the world. As of late, the health-care sector has come under fire from the Obama administration and health-care reform is clearly in President Obama's sights. But not all aspects of the health-care sector will be under the same pressure should reform take place. Below is our take on how reform would impact the various underlying holdings that make up IXJ.

The Underlying Holdings
Before an investor buys an ETF the first thing he or she should do is examine what's in the fund and how it compares with competitors.

Similiar to the overall health-care sector's industry breakdown, big pharma soaks up the lion's share (roughly two thirds) of the cap-weighted IXJ. Rounding out the portfolio is a sprinkling of managed-care firms, mature biotech companies, and medical device firms. While investors can obtain similar sector exposure (with lower expense ratios) from funds like the  Vanguard Health Care ETF (VHT) and  Health Care Select Sector SPDR (XLV), neither of these ETFs contains firms domiciled outside North America. Thus, investors in this ETF would essentially be paying a slight premium (of 0.25% to 0.26%) on the expense ratio here in order to gain exposure to foreign firms like  Novartis (NVS), Roche (RHHBY), and  Sanofi-Aventis (SNY).

It is important to note that international firms make up five of the ETF's top 10 holdings and represent approximately 35% of the fund's assets. Keep in mind these differences in composition when selecting an ETF to gain health-care exposure; investors who aren't particularly enthused at the idea of bulking up their international exposure may be better suited going with a cheaper alternative. As with any asset-allocation decisions, before deploying this satellite fund, investors should consider its role in the context of their broader portfolio.

Our Fundamental Take
Health care is considered a classically defensive sector due to the noncyclical nature of the industry; people get sick and require treatment regardless of the state of the economy. Nonetheless, the sector has hit somewhat of a lull in recent years, as some key blockbuster drugs lost exclusivity and a blitz of competition from generic drug firms ensued. Currently, there are two main themes to consider before committing an investment here: health-care reform and the mega-merger activity among the pharmaceuticals.

In our view, the issues on the regulatory front carry particular significance, as major policy shifts could change the industry landscape and send ripples throughout the sector. Furthermore, the Obama administration has sent a clear message: Health-care reform will not take a back seat to the economic crisis, and the system could undergo a significant overhaul as early as next year.

Not surprisingly, news of reform as well as speculation surrounding the administration's 2010 budget proposal has wreaked havoc across the sector. In short, there is a wide range of potential outcomes that depend on which initiatives ultimately get signed into law. And, as we've all learned, if there's one thing the market doesn't like, it is uncertainty.

The scant details of the Obama administration's plans that have emerged so far haven't quelled investor fears. Expectations include far-reaching proposals, such as direct price negotiations between the government and drugmakers, drug reimportation, competitive bidding, bundled payment system for hospital reimbursement, and even socialized medicine. Due to the fact that pharma and biotech firms make up the overwhelming majority of this index, we think would-be investors should focus on the impact that the administration's various proposals would have on the drugmakers.

Two major components of the administration's plan could have adverse effects on big pharma. First, President Obama supports allowing Medicare to negotiate drug prices directly with drugmakers. Giving this power to the government would reduce drug prices and create some serious hurdles for pharmaceutical firms. Second, Obama's plan would allow for drug reimportation in an effort to lower prices. However, in this case we think that any reimportation plan would be met with significant resistance from the Food and Drug Administration due to safety concerns. Regardless of whether these concepts take form, it's clear that big pharma could have a target on its back.

Shares of many drug developers have in fact struggled since the budget was released, thanks to harsh rhetoric toward branded-drugmakers which has stoked fears of pricing control. We think there is definitely some stigma attached to manufacturers of prescription drugs. This could facilitate the passage of certain measures aimed at curbing drug costs, such as uniform reimbursement under both Medicare and Medicaid.

On a more positive note, this fund's portfolio doesn't contain fly-by-night start-up drugmakers who can fall subject to near-term financing issues or those firms with highly concentrated product portfolios that can lead to incredible volatility. To that end, an ETF makes a lot of sense for health-care investors. No matter how deep your knowledge of individual stocks, you can always be shocked by a bolt from the blue. Think of the challenges raised (and wealth destroyed) with  Wyeth's  fen-phen,  Merck's (MRK) Vioxx, or  Boston Scientific's (BSX) drug-eluting stents. A product can be wildly successful one year and spawn thousands of lawsuits the next.

Such company-specific risks get diversified away in the ETF format. Granted, all health-care companies face the risk of Congress changing the rules--whether it's Medicare reimbursement, nationalized health care, or stricter Food and Drug Administration guidelines--which could potentially hammer all the stocks in this portfolio to some degree. But by buying at a discount to the intrinsic value of the portfolio, an investor can mitigate even this risk.

Morningstar.com Premium members can gain access to the full report for iShares S&P Global Healthcare as well as more than 300 other individual ETF and ETN reports.

 

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