Fund Spotlight: Evaluating Healthcare ETF’s

The healthcare sector was hit by weakness in biotechnology and pharmaceutical stocks early in the year, but the past month has seen a reversal in the sector’s favor. While pharmaceuticals and biotechnology peaked in July 2015, the healthcare sector continued to push on. Even into January 2016, broad healthcare funds were matching the performance of the S&P 500 Index. Medical devices have been the only healthcare subsector consistently outperforming the S&P 500 Index but it isn’t large enough to pull the overall sector higher. Meanwhile, as the stock market rallied from early February until today, biotechnology and pharmaceuticals were still flat and didn’t begin a rally until late March.

Momentum-based trading weighed heavily on these two subsectors. Biotech enjoyed a particularly long run as the leading sector of the bull market, from the start of 2012 to summer 2015. As is typical of momentum leaders, sell-offs can be brutal in the short term, and by the end of 2015 biotech companies were again trading at prices value investors found enticing. Shares kept sliding, however, as investors lost patience.

Biotech and pharma shares were also hit by a wave of negative headlines. Martin Shkreli became the poster boy for greedy pharmaceutical companies in late 2015, pulling the issue of high drug prices off the back burner and into the presidential debate. Several presidential candidates have weighed in since then, issuing market-moving statements. This year, Gilead (GILD) was threatened by the Massachusetts attorney general over the pricing of its hepatitis C drug. This sentiment soon changed to concerns that market competition would drive hepatitis drug prices lower, after Merck (MRK) launched a competing drug at a much lower price. Valeant (VRX), a firm that built itself through debt-backed acquisition, saw its share price tumble in March amid an SEC investigation into its accounting and a delayed 10-K filing that threatened to create a technical default on some of its bonds. Finally, the planned merger of Pfizer (PFE) with Allergan (AGN) was nixed following a change in the rules governing corporate inversions.

The sell-off in healthcare has apparently completed and investors have grown increasingly optimistic. Legitimate concerns have been priced into shares and then some, with fast-growing biotechnology firms sporting price-to-earnings ratios below 10, and many pharma stocks in the low double digits. The flurry of negative hits the industry has taken over the past four months is unlikely to be repeated.

There are numerous factors working in favor of the healthcare sector. Demographics remain unchanged: the population is aging, a trend that will continue. The Affordable Care Act spurred spending and medical inflation is among the highest in the economy. While we hate to see insurance premiums and drug costs rise, the flip side is rising earnings for healthcare companies. In sum, a storm of short-term and momentum-driven factors conspired to batter the healthcare sector, pushing many stocks to attractive valuations relative to long-term economic and demographic trends.

Investors have various options when it comes to healthcare ETFs, with dozens of choices spread across multiple subsectors. There are only a few major ETFs, however, that offer broad, passively indexed coverage. The largest is SPDR Healthcare (XLV), followed by Vanguard Healthcare (VHT), iShares U.S. Healthcare (IYH) and Fidelity MSCI Healthcare (FHLC). Below we’ll break down the funds to see which may be most appropriate for your portfolio.

Assets and Volume

One of the first and best ways to eliminate an ETF from consideration is to look at the assets under management and the average trading volume. Unless you’re an experienced investor comfortable with limit orders, buying and selling low-volume ETFs is difficult. These funds are also at greater risk of a “flash crash” due to liquidity drying up at the worst possible moment during market panics. Sometimes there’s no other option for unique exposure, but when it comes to healthcare, there are many high-volume funds to choose from, so there’s no reason to take any additional risk. Each of the four funds discussed in this article have adequate daily volume.

Fees and Expenses

Vanguard and Fidelity offer commission-free trading for their funds on their platform. XLV and IYH are not available commission-free at any brokerage, but typically any fees would be very inexpensive.

FHLC and VHT are the most cost-effective, charging 0.09 percent and 0.12 percent, respectively. XLV charges 0.15 percent and IYH charges 0.43 percent.

Portfolio

Aside from the known cost of fees, index construction is the most important factor in choosing a fund. These funds are very similar, using passive market capitalization weighting strategies. They all have identical top-10 holdings, down to the order of largest allocation. The main difference among the four comes from the weighting of these holdings, which is a result of the number of different positions in each portfolio.

Investors who want to lean away from concentration in the largest holdings should pick FHLC or VHT, while those who want more exposure to large and mega caps should pick XLV.

Performance

Since the inception of FHLC on October 21, 2013, all the funds have experienced similar returns. XLV has led with a 37.76 percent gain, while VHT increased 37.08 percent. FHLC climbed 36.12 percent, followed by IYH’s 35.94 percent return.

Fees explain much of IYH’s underperformance, but over the past 10 years, IYH has outperformed XLV with an annualized gain of 10.59 percent versus 10.42 percent, but both were bested by a 10.85 percent return for VHT.

XLV provides the highest yield at 1.52 percent, followed closely by VHT at 1.46 percent. FHLC and IYH yield 1.40 and 1.19 percent, respectively.

It’s tough to make a call based on performance, but it does appear that in the short term, we can see an effect from IYH’s higher fees.

 Conclusion

A survey of the fund characteristics indicate IYH is high-cost and low-yield, good enough reason to set it aside. For investors looking to invest a small amount, the commission-free trading offered by Vanguard and Fidelity is an excellent reason to choose their offering if you’re a customer, and both are low cost with similar performance. XLV would be the best option for those who prefer higher exposure to a smaller number of large-cap names.

There are other options for more targeted healthcare exposure, but these funds provide broad exposure and limit subsector risk over the next year. If you have any questions about these ETFs or other healthcare-related options, please call us at (877) 252-5372.