Low-Cost Exposure to U.S. Healthcare Firms

Investors seeking high-quality North American healthcare companies can consider

Health Care Select Sector SPDR

XLV. Given the sector's lack of economic sensitivity, investors seeking a defensive tilt for a broad portfolio may view this exchange-traded fund as a suitable satellite holding. XLV's holdings comprise all of the S&P 500's healthcare exposure, so owning this ETF and

While XLV offers exposure to many subindustries within the healthcare sector, Big Pharma firms comprise 39% of the fund's assets. XLV's heavy Big Pharma exposure shouldn't by itself deter investors, however, as the subsector weightings are representative of the entire healthcare industry.

This fund's historical volatility has been relatively low. Its standard deviation during the past decade was 13.9%, which is more than a full percentage point less than the 15.1% posted by the S&P 500.

Fundamental View Historically defensive and minimally cyclical, the U.S. healthcare sector is gaining added growth from an aging America. Demand is relatively stable because people need treatment regardless of the economy, and the approximately 77 million U.S. baby boomers' need for greater treatment translates to compelling secular growth. An aging population bodes well for the industry's future, as the majority of people's lifetime medical costs are spent in their final few years.

Many dynamics are affecting U.S. healthcare firms. Pharmaceutical and device firms continue to merge in an effort to create scale and focus on key strategic areas. Also driving mergers are firms' desires to cut costs, tap growth avenues, deploy previously trapped overseas cash, and reduce acquisitors' tax rates through overseas acquisitions. From an innovation standpoint, drugmakers are focusing most on specialty care. As a result, pharmaceutical and biotech firms are targeting smaller patient populations, particularly in oncology, virology, and immunology. Innovating in areas of previously unmet needs should offer higher odds of approval by U.S. regulators and better pricing power for drug firms. (And despite increasing political rhetoric from lawmakers, drug and biotech firms' pricing power should remain strong, though drug pricing concerns likely will cause higher volatility in pharmaceutical and biotech stocks.) Even drugs aimed at smaller patient populations can become meaningful contributors to large drug firms--if not downright blockbusters--particularly if these innovations' price tags are of a magnitude of

Healthcare utilization is increasing slightly, driven mostly by a stronger economy and higher insurance coverage from U.S. healthcare reform. With mandated healthcare coverage in the United States and expanded government insurance, more are seeking out treatment, which is a net positive for healthcare firms.

An aging China offers medium- and long-term opportunities for U.S. healthcare firms. As the country ages and becomes wealthier, Morningstar's equity analysts anticipate the Chinese market will start moving the needle for large U.S. players in a variety of subsectors, including pharmaceuticals and medical technology. Assuming a normal path as China grows richer and older, healthcare's share of Chinese gross domestic product should grow from about 5% today to 40% by 2022. (China's market for health products and services currently is roughly the same size as that of Germany and France combined.) For this growth to take place, China needs to continue spending on its healthcare infrastructure, with the central and local governments expanding spending on hospitals. Another current issue in China relates to corruption, as there have been recent bribery scandals in the pharmaceutical and medical-device industries. Chinese authorities have begun taking steps to tighten up pharmaceutical industry practices and should do the same with device firms.

While the investment community understands the various sector headwinds, it nonetheless has settled on a largely positive long-term outlook for the sector.

Portfolio Construction

This ETF contains the 56 healthcare companies in the S&P 500, weighted according to market cap. These include firms focused on drugs (both Big Pharma and biotech), healthcare equipment and supplies, hospitals, medical devices, and health insurers. Because the index draws its constituents from the broader S&P 500, it has an inherent quality screen. In fact, eight of the top 10 holdings sport wide Morningstar Economic Moat Ratings. About 63% of assets are invested in wide-moat stocks, and 94.5% of assets are invested in companies with narrow or wide moats. S&P 500 holdings have to meet the standards of the S&P's selection committee, and this includes profitability and status as a leading U.S. company. Because the criteria eliminate foreign healthcare companies, the index excludes international healthcare behemoths such as

Fees The fund's 0.14% expense ratio makes it one of the cheaper healthcare sector ETFs available. Its estimated holding cost is also 0.14%, suggesting that this fund has tracked its index very well. Estimated holding costs are primarily composed of the expense ratio but also include transaction costs, sampling error, and share-lending revenue.

Alternatives

Fidelity MSCI Health Care ETF FHLC is inexpensive, with a 0.12% fee. However, FHLC has fewer assets than competing ETFs, which could make it more expensive to trade. FHLC tracks a slightly different index--the MSCI USA IMI Health Care Index--while VHT tracks the MSCI U.S. Investable Market Health Care 25/50 Index. The indexes are very similar, with nearly identical weighting schemes, similar numbers of holdings, and minimal differences in holdings. Fidelity customers with a minimum balance of $2,500 can buy FHLC commission-free. Fidelity may charge a trading fee to those who sell after a short-term period (30-60 days); customers who own for longer periods of time are not subject to any such fee. FHLC holds 350 firms.

Investors seeking some international flavor for their healthcare exposure can consider

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