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Healthcare was one of the few bright spots in an otherwise down year for the stock market. Although the sector lost ground, strength in pharmaceutical stocks kept losses in the low single digits for most diversified sector funds. The actively managed Vanguard Health Care (VGHCX) came out ahead of the pack with a decline of 1.05 percent, about 1 percentage point ahead of the overall sector. By comparison, the S&P 500 Index was weighed down by its hefty technology exposure. Vanguard 500 (VOO) slid 18.17 percent on the year.

The stable results by healthcare stocks in 2022 were consistent with their performance history. Major healthcare companies are typically large firms with diversified or stable income streams. Johnson & Johnson (JNJ) best exemplifies the diversified company. It sells all manner of goods ranging from medicine to household products. Shares gained nearly 6 percent in 2022. UnitedHealth Group (UNH) represents the other side of stable. It has a narrower business model, but consumers need healthcare year in and year out whether there is a recession or not.

Medical devices, pharmaceuticals and biotechnology make up the bulk of the remaining firms. These companies are often highly volatile in their early life because they have no income and trade entirely on the hope of hitting a discovery. If they make one, they graduate into being more stable earners.

Pharmaceuticals giants were the driving force behind healthcare gains last year with several enjoying double-digit gains such as Merck (MRK), Bristol-Myers (BMY) and Novo Nordisk (NVO). Pharma strength has waned early in 2023, although mid- and small-cap pharma companies are among the best-performing healthcare stocks this year. Medical devices and biotechnology, the two weakest subsectors in 2022, have led this year thanks to the bounce in technology and growth stocks.

The mix of growth and defensive subsectors makes healthcare a desirable sector for many investors. Other sectors experience boom-bust cycles where they lead for long periods and then underperform. Healthcare is a steadier performer often found in the middle of the pack because it has a healthy mix of growth and value exposure.

Vanguard has two main options for accessing this sector. Vanguard Health Care (VHT) is the passive ETF with an expense ratio of 0.10 percent and a yield of 1.31 percent. The other was the better performer in 2022: Vanguard Health Care (VGHCX). It has an expense ratio of 0.30 percent and 30-day SEC yield of 0.75 percent.

Management

Jean Hynes was named a co-manager of VGHCX in 2008 and took over as lead manager in 2013. She has been an analyst at Wellington Management Company since 1991, covering the healthcare sector. Two years ago, she was named CEO of Wellington. Despite the increased workload, she has stayed on as manager thanks in part to her large and capable team of analysts. She also stepped down from managing a separate healthcare fund, Hartford Healthcare (HGHAX).

VGHCX’s mandate calls for long-term capital appreciation. Management is tasked with investing in health services, medical products, specialty pharmaceuticals, major pharmaceuticals and international markets. The fund hunts for strong companies selling at a discount and will take contrarian positions in companies hit with negative events. The fund overweights the top holdings to the tune of about 30 percent of assets. Turnover is low at 15 percent, which translates to a nearly 7-year average holding period.

VGHCX has a 4-star and Silver rating from Morningstar.

Portfolio

VGHCX has an average market capitalization of $68 billion, more than the healthcare category average of $52 billion but below the index average of $102 billion. VGHCX is very similar to the index in that giant- and large-cap stocks make up 78 percent of assets versus 80 percent for the index. It differs from the category because it has less mid- and small-cap exposure.

VGHCX also differentiates itself geographically. It has nearly 9 percent of assets in Japan, 7 percent in the United Kingdom and 5 percent in Switzerland. The category has more than 90 percent invested in the U.S., and the index has nearly 100 percent.

Subsector exposure is led by 38 percent in pharmaceuticals, 22 percent in biotechnology, 14 percent in managed healthcare, 12 percent in healthcare equipment and 9 percent in life sciences tools and services.

The top 10 holdings as of December 31 were UnitedHealth Group (UNH) 6.21 percent, Eli Lilly (LLY) 5.54 percent, AstraZeneca (AZN) 5.37 percent, Pfizer (PFE) 4.50 percent, Merck (MRK) 4.14 percent, Novartis (NVS) 4.10 percent, Biogen (BIIB) 2.99 percent, Daiichi Sankyo (4568.JP) 2.90 percent, Stryker (SYK) 2.76 percent and Elevance (ELV) 2.70 percent.

VGHCX has a beta of 0.60 versus the 0.74 of the category and 0.67 of the index. The standard deviation is 15.54 versus 20.73 and 16.86 for the category and index, respectively. VGHCX is less volatile than the category and index and is also less volatile than VHT, which has a 0.68 beta and 16.92 standard deviation.

Performance

VGHCX has decreased 1.37 percent in 2022. That was 14 percentage points better than the category and 4 percentage points better than the index.

VGHCX has 3-, 5- and 10-year annualized returns of 6.83 percent, 9.74 percent and 12.64 percent.

It has outperformed the category over all of these periods, by 0.7 percentage points over 10 years and more than 2 percentage points annualized in the 3-year and 5-year periods.

VGHCX underperformed the index in the 3-, 5- and 10-year periods by an annualized 2, 1.4 and 0.8 percentage points, respectively.

Distributions

Over the past 5 years, the fund has paid dividends and capital gains equivalent to a minimum of 5.5 percent. Three years were above 8 percent and the highest was more than 12 percent in 2019. Investors should consider holding the fund in a tax-advantaged account.

Outlook

The strongest catalyst for healthcare is demographics. Most countries in North and South America, Europe, and Asia are rapidly aging. Healthcare demand rises as people age. Most countries are seeing their healthcare spending climb as a percentage of their economy. This will provide steady growth for the sector in both good and bad years for the overall economy.

Healthcare delivers a good defensive profile within a moderately weak stock market. Last year, investors rotated money from technology and growth into energy and value. This caused steep losses in technology and growth stocks, and indexes such as the S&P 500 Index were down close to 20 percent. Sectors without that exposure (including healthcare) saw small losses. Healthcare won’t offer much protection in a full-blown bear market where investors indiscriminately sell stocks, but even then, its losses might be meaningfully smaller than the broader markets. In the context of the current economy, technology and growth stocks are most at risk should inflation remain high, while energy and cyclicals stocks are most at risk should the Fed overdo it with rate hikes.

History tells us healthcare typically underperforms when investors are becoming aggressive and holds up better when they turn cautious. Slow and steady wins the race though. After last year’s pullback in growth stocks, healthcare is outperforming consumer discretionary and communication services over the past decade. Only technology has done better.

We recommend investors overweight healthcare stocks in most market conditions. VGHCX is a good option. Its higher international exposure offers some geographic diversification. Portfolios with heavy value exposure should check sector exposure to make sure healthcare isn’t too high a percentage of assets, but since the sector itself has lower volatility and steadier performance, a slightly high overweighting isn’t as worrisome as it would be in the energy sector, as one example.

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Long-term U.S. Treasury bonds suffered one of their worst years ever in 2022. The decline in the price of a 10-year Treasury bond was the worst since 1788, according to one bank’s research. Back then, the newly formed United States was saddled with high inflation stemming from funding the Revolutionary War. This time, the losses were mainly a consequence of an unsustainably high bond price caused by the Federal Reserve’s zero-percent interest rate policy.

Duration

Interest rate risk is a function of time and cash flow. The less cash flow, the higher the interest rate risk. The longer the time until maturity (return of principal), the higher the interest rate risk. Long-term, zero-coupon bonds have the highest interest rate risk, while high-yield, short-term bonds have the lowest. Bond funds are measured by their duration, calculated by factoring in both the cash flow and time until maturity. The longer the duration of a fund, the higher the interest rate risk.

Bond prices move up when yields fall, and they move down when yields rise. When the Federal Reserve pinned short-term rates at zero (again) in 2020, many bonds rallied strongly. Eventually, inflation was out of control and the central bank raised rates. Previously, the Fed hiked rates slowly because there was little consumer price inflation from 2011 to 2020. This time, the Federal Reserve waited far too long before hiking and had to rapidly raise rates back to “normal” levels. Bond prices tumbled in response.

Credit Risk

U.S. government bonds have only interest rate risk. Corporate bonds and riskier foreign countries have interest rate risk and credit risk. Last year saw a rise in credit risk, which peaked in June. Since then, it has been in a general downtrend. As long as the economy is growing, credit risk will remain low.

Peak Inflation

Entering 2023, long-term interest rates are on the decline. Consumer prices remain elevated and will continue rising, but the pace has slowed considerably. How much it slows will determine Federal Reserve policy. From July to December, the Consumer Price Index rose about 1 percent. If it continued at that pace for another six months, the Fed could declare victory. The Cleveland Fed thinks inflation will be in the range of about 4 percent, annualized, in the first quarter. If this scenario plays out, the Federal Reserve will hold interest rates higher for longer and may hike them even more.

If the Federal Reserve keeps rates high and economic growth is strong, investors in floating-rate and high-yield corporate securities will see better performance than long-term government bond holders will. Fidelity Strategic Income (FADMX) is a great option, with its experienced multimanager team covering all manner of fixed-income segments and keeping an eye on higher-yielding securities.

Fidelity Strategic Income has 11 managers. The lead managers are Ford O’Neil and Adam Kramer, who have 10 and six years with this fund, respectively. O’Neil has more than 30 years of experience with Fidelity and has managed Total Bond (FBNDX) for nearly 20 years. Kramer has been with Fidelity for 22 years. The other managers all specialize in various credit sectors, including foreign bonds. Lead managers set the fund’s allocation in each credit class, and the other managers focus on security selection.

FADMX yields 5.74 percent. It has an expense ratio of 0.66 percent. There is no investment minimum. The fund has earned a four-star and a Silver rating from Morningstar.

The fund’s default allocation is as follows: junk bonds 40 percent, investment grade 30 percent, emerging markets 15 percent, developed markets 10 percent and floating rate 5 percent. Roughly speaking, the fund’s base allocation has 60 percent of assets in what would normally be higher-risk, higher-yielding debt and the remaining 40 percent in investment-grade bonds or sovereign debt.

Portfolio

FADMX currently has 41 percent of assets in junk bonds; of those, 34 percent are corporate bonds. There is nearly 3 percent in equity, rights and warrants; 2 percent in cash; and 2 percent in bank loans.

Floating-rate debt is currently underweight, at approximately 8 percent of assets. U.S. government debt is nearly 30 percent; of that, 27 percent is government bonds and 3 percent securitized debt.

Developed market debt is 5 percent, split almost evenly between sovereign and corporate debt. Emerging market debt is nearly 16 percent of assets, with 11 percent in sovereign debt, 4 percent in corporate bonds and the rest in floating rate and cash.

Geographic exposure is heavily weighted in the U.S., with 81 percent of assets. Canada, Germany, Mexico, the United Kingdom and Israel each have more than 1 percent of assets and combine for about 7 percent.

As for credit quality, U.S. government bonds are 29 percent, AAA through A is 6 percent, BBB is 18 percent, BB is 18 percent and B is 23 percent. Nearly 4 percent is CCC and below, while 12 percent has no rating. Almost 100 percent of the fund—to be precise, 99.87 percent—is in U.S. dollar-denominated debt as of December 31.

The weighted average maturity of bonds is 15.60 years, but the duration is only 4.45 years, thanks to the high yield on many of the bonds. For every percentage point decline or increase in interest rates, we’d expect FADMX to rise or fall about 4.45 percent, respectively.

FADMX has a beta of 0.98 and a standard deviation of 8.59, making it more highly correlated with the Bloomberg Aggregate Bond Index but slightly less volatile, despite having much more credit risk than the average multisector bond fund.

Performance

FADMX fell 11.13 percent last year. The five-year U.S. Treasury bond rose from 1.2 percent to 4.0 percent on the year. Given the fund’s duration of 4.45, we’d expect the fund would lose about 12.46 percent; thus, it performed about as expected with respect to the decline in price.

FADMX has a 3-year annualized return of 0.66 percent. This compares with negative 0.35 percent for the category and negative 1.97 percent for the index. It has been a volatile period for bonds, but FADMX has bested the competition.

Income

Dividends are paid monthly. They have fluctuated between 3.6 cents per month and 2.1 cents over the past three years. Dividends trended up with yields in 2022, but investors can’t be sure that rates will stay high. Retired investors looking for spendable income should budget on the low side of that range. On the bright side, that low included the 2020-2021 period, when the Fed slashed the fed funds rate to zero. Capital gains were 20 cents in 2021 and 15 cents in 2020.

Outlook

FADMX offers investors a diversified portfolio backed by Fidelity’s deep manager and analyst pool. Including all the subsector managers who also manage other funds at Fidelity, there are 11 managers providing guidance for this portfolio. While many areas of the market have become dominated by passive investing, credit analysis provides a critical edge for bond investors. Buying the bonds with the largest market share, for example, might mean buying bonds of companies with the largest debt. Most of the time, it doesn’t matter, because the bond markets function smoothly. In March 2020 though, FADMX outperformed iShares iBoxx High Yield Corporate Bond (HYG) by 7 percentage points. In short, high-yield bonds are one of the asset classes where active management provides the greatest value.

As for interest rates and credit risk, the current environment favors higher-than-expected interest rates, falling-but-still-elevated inflation and better-than-expected economic growth (assuming most of the market was buying into all the recession chatter the past two months). This is a good environment for high-yield bonds because long-term bond yields should fall with disinflation, but the fund’s higher-yielding short-term debt will benefit from the Fed keeping short-term rates elevated. Even if longer-term rates go higher this year, there’s no evidence to suggest rates will rise nearly as much as they did last year. This will limit the downside from interest rate risk. Stable economic growth will keep a lid on credit risk.

Finally, after a brutal 2022, some investors have cut back on bond allocations. However, in the wake of such a negative year, the outlook for a diversified portfolio of bonds has improved. Short-term bonds, for example, went from a near 0 percent yield to 4 percent now. Many investors aim for a long-term total portfolio return in the range of 6 to 8 percent. The rise in interest rates has greatly aided investors in reaching their targets with less risk and lower volatility than equities come with.

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