From the July 2007 issue of Research Magazine • Subscribe!

July 1, 2007

Inside HealthShares

It's hard to ignore the pressure that an aging population is already putting on the U.S. healthcare system. What's the best way to take advantage of the healthcare boom?

Jeff Feldman, founder and chairman of the New York City-based XShares Group, thinks his HealthShares are the answer. Each of the 17 HealthShares is an exchange-traded fund that targets industry-specific medical therapies and treatment devices. With the exception of the HealthShares Composite (NYSE: HHQ), which has 80 holdings, each ETF owns between 22 to 25 stocks in a focused healthcare segment.

Competing healthcare ETFs -- such as the Healthcare Select Sector SPDRs (AMEX: XLV) (54 holdings), iShares Dow Jones U.S. Healthcare Sector (NYSE: IYH) (159 holdings) and the Vanguard Healthcare ETF (AMEX: VHT) (261 holdings) -- charge a lot less than HealthShares' 0.75 percent in fees and are considerably more diversified. According to XShares, that's exactly the problem: Broadly diversified healthcare ETFs aren't exploiting the small pockets of opportunity in the cutting-edge field.

The first five HealthShares ETFs began trading on the New York Stock Exchange in late January.

Beyond healthcare, the company is planning additional funds using proprietary indexes or in conjunction with strategic partners. One such partnership is the expected launch of ETFs based upon 22 Standard & Poor's Custom/State Shares, composed of public securities of issuers in a specific state representing every region of the U.S.

Research: What makes healthcare such a compelling investment opportunity?Feldman: Healthcare is a $2 trillion business or 16 percent of the U.S. economy. Healthcare expenditures are currently growing more than 10 percent per year, which means this segment will double in 7 years. The 78 million baby boomers are now 43 to 61 years of age. They are still basically healthy, but this huge chunk of the U.S. population is getting close to the age when it must begin to lean heavily on the healthcare system. That system is already in deep trouble as 45 million people have no health insurance, Medicare and Medicaid have enormous unfunded liabilities totaling several trillion dollars, there is massive waste and fraud in the third-party payer system and employers are working feverishly to reduce their contributions to their employees' healthcare. While all this is going on, the pharmaceutical industry has matured into an efficient oligopoly whose entire business model is based upon treating symptoms after a patient is sick.

There are plenty of healthcare ETFs to choose from. Why not just go with a Dow Jones or S&P healthcare index? Look at the components of those funds (or any other broad pharmaceutical or healthcare fund) and you will see that the majority of the portfolios are invested in the largest-cap companies. Most of the growth in the industry is not going to take place in the larger-cap companies. Until HealthShares, there was no opportunity to create a portfolio that gives access to innovation in specific sub-segments of the healthcare sector with the mitigation of risk.

Let's talk about the HealthShares Composite (NYSE: HHQ). What does it do?The Composite includes the top five companies by market capitalization from each of our 16 HealthShares therapeutic verticals. We do not think of it as a staple, but rather a default investment for those who want general exposure to the biotech sector.

Cancer and heart disease are top killers around the world and in the U.S. HealthShares offers two such ETFs. How close are these companies to actually solving these complicated diseases?Currently, we treat the symptoms of those diseases. If a patient has cancer, chemotherapy or radiation is used to destroy the tumor. Recently, a biotech company called Dendreon received preliminary approval for a prostate cancer vaccine. This vaccine deals with the cancer at the molecular level. While it is potentially an important drug, only about 10 percent of prostate cancer patients will benefit from it. That is still enough to make it a $2 billion drug.

Coronary blockage is dealt with through surgery. As we evolve from pharmacology to customized medicine, we will increasingly see that the new drugs will benefit only a subset of the total patient population because of the genetic differences in human beings.

Is someone who isn't part of the medical field at a disadvantage in understanding which of these areas provides the better opportunity?I agree with your assessment. But there are people who are knowledgeable about these companies and therefore may find these portfolios useful. Then there is another perspective. A young diabetes patient who is facing the cost of treating the disease for the rest of his or her life might see a benefit in owning a portfolio of the very companies that will provide treatment. In general, we have found that individuals who deal with chronic disease on behalf of a family member or themselves (over 100 million people in the U.S. have some form of chronic disease) are quite familiar with the companies that are working on new therapies and have an interest in investing in them.

Is there a relationship between the explosive growth of both hedge funds and ETFs? Also, what does it mean for middle-of-the-road mutual funds?I believe these products have developed independently of each other and for different reasons. Hedge funds have been around for decades but have recently come into vogue because pension funds find themselves behind the eightball. Just as liquidity drove the 1982-2000 bull market, that same phenomenon is driving private equity and hedge fund returns. ETFs are a product of technology; they are an evolutionary improvement over mutual funds. I believe ETFs will continue to draw assets from mutual funds though a bull market will stop that process to some extent. Hedge funds, too, will suffer in a bull market.

What's your assessment of the ETF marketplace? Some argue that it's become too crowded and if we see the introduction of active ETFs it could get even worse. What do you think?There are about 12 firms with the exemptive order necessary to issue ETFs. I expect there will eventually be at least several dozen. There are about 7,000 mutual funds with $10 trillion in assets. There are projections that ETFs will reach $2 trillion in the next four years or 20 percent of mutual funds' AUM. That would imply we could have 1,400 ETFs (there are currently less than 500).

I believe the market doesn't need another mid-cap SPDR or any other broad index funds, for that matter. The growth of ETFs will be in narrow well-defined indexes across both style and sector. There will be ETFs that replicate a variety of investment strategies for equities, fixed-income and commodities as well as combinations of all three. There will be more regional ETFs and affinity group ETFs. Far from being crowded, the field is sparse.

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Ron DeLegge is the San Diego-based editor of www.etfguide.com.

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