From the May 2010 issue of Research Magazine • Subscribe!

May 1, 2010

What's Next for Health Care?

How health care reform will impact health care ETFs.

The health care sector has never seen anything like this and neither has the American public.

After months of political wrangling, the Affordable Health Care for America Act was signed into law by the President.

The act will extend health insurance coverage to roughly 32 million Americans without it. The new law will also require most Americans to purchase health insurance coverage and will provide subsidies for private health care to low- and middle-income families.

In the meantime, as the legislative details on the measure becoming clearer, investors are asking: What does it mean for the health care sector? Is it doomed?

The two primary groups impacted by the new health care bill are health insurers and the broader health care arena, which encompasses hospitals, medical device makers and pharmaceutical companies.

Let's analyze the key healthcare ETFs. (Performance figures are through the March 24 market close.)

Health Care Sector SPDR (XLV)
This ETF follows health care stocks within the S&P 500. This particular industry sector covers stocks of companies involved in health care equipment and supplies, health care providers and services, biotechnology and pharmaceuticals makers. The health care industry accounts for 12 percent of the S&P 500's overall sector weighting, making it the third largest sector within the index just behind financial stocks (XLF) and technology (XLK). With $2.7 billion in assets, XLV is the largest health care ETF.

This year, XLV has climbed 3.44 percent compared to a 4.68 percent gain in S&P 500 (SPY). Johnson & Johnson, Pfizer and Abbott Laboratories are among the fund's largest holdings. XLV's annual expense ratio is currently 0.21 percent.

iShares Dow Jones U.S. Healthcare Sector Index Fund (IYH)
The Dow Jones index that this particular ETF follows provides market exposure to 131 health care stocks. Biotech and pharmaceutical stocks dominate IYH's sector exposure with a weighting of some 61 percent. Health care services and equipment companies represent around 35 percent of IYH's weighting.

Companies within the index are selected passively and weighted according to their market capitalization or size. The median market size of healthcare stocks within IYH is around $2 billion.

IYH has risen 3.96 percent this year, and the fund's annual expense ratio is 0.48 percent.
Vanguard Healthcare ETF

The Vanguard ETF follows the MSCI US Investable Market Health Care 25/50 Index. This particular healthcare ETF is the most diversified among similar offerings and owns around 309 stocks. The median market size of health care stocks within VHT is around $39.5 billion.

Vanguard recently revamped its sector ETFs by constructing MSCI 25/50 sector indexes. The new indexing methodology helps the funds to comply with IRS diversification rules.

This year VHT, as of late March, was ahead by 5.24 percent. The fund's annual expense ratio is 0.25 percent.

Rydex S&P Equal Weight Health Care ETF (RYH)
This ETF shadows health care stocks within the S&P 500, but with a twist. Instead of weighting the companies by their market capitalization or size, it weights each stock equally. The net effect of equal weighting a stock index is a bias towards mid and small company stocks.

RYH is ahead by 6.58 percent this year and each one of the 51 stocks within the fund receives an equal weighting. The underlying index is rebalanced every quarter. RYH's annual expense ratio is 0.50 percent.

SPDR KBW Insurance ETF (KIE)
KIE follows the KBW insurance index, which contains market exposure to publicly traded companies involved in personal and commercial lines, property/casualty insurance, life insurance, reinsurance, insurance brokerage and financial guarantee. KIE's top holdings include AFLAC, Chubb and Metlife.

KIE has soared 15.64 percent year-to-date. The fund has $186 million in assets and owns around 26 stocks. KIE's annual expenses are 0.35 percent.

Bond Market Votes

Although many financial professionals are trying to determine the effect of new legislation upon the health care sector, the largest impact might actually be felt by the government.

In March, the cost of short-term borrowing for leading U.S. corporations was less than the U.S. government's borrowing costs. Data compiled by Bloomberg showed that corporate debt from Berkshire Hathaway, Procter & Gamble, Johnson & Johnson and Lowe's all traded at lower yields than Treasuries with similar short-term maturities. This extremely rare event signals a marked lack of confidence in the creditworthiness of U.S. government debt, which once was believed to offer a risk-free rate of return.

Currently, the U.S. government's budget deficit has soared to a record 10 percent of gross domestic product. The splurge can be credited to taxpayer-funded programs to prop up the housing market, multibillion dollar economic stimulus efforts and spendthrift politicians. Deficits haven't been this high in relation to GDP since the late 1940s.

According to the non-partisan Congressional Budget Office, the new health care bill will cost around $938 billion over 10 years. Purportedly it will reduce the federal deficit by $138 billion over the same time frame. Good as it sounds, the bond market doesn't believe the CBO, proving once again the only place on the planet with more fuzzy math per capita than Wall Street is Washington D.C. Does saving money by spending nearly a trillion dollars really add up?

Medical Innovation Needed

For all of its shortcomings, the health care sector is here to stay. Aging baby boomers and demographics mean that innovation within health care is badly needed.

It is still too early to make confident assessments of the diverse effects the new bill will have on the health care sector. For example, with health coverage becoming a requirement, health insurers will have more customers, but they will also be forced to accept higher risk clients with pre-existing conditions. In addition, health insurers will face new competition from government-subsidized plans.

According to New York-based AltaVista Research, health care stocks inside the S&P 500 are trading at a discount to the market. Based upon 2010 earnings estimates, health care stocks currently trade at a P/E ratio of 11.8, which is a discount to the S&P 500's 14.1 multiple. Earnings per share are expected to rise 7.5 percent based upon 2010 estimates.

A radical transformation of the health care sector is now underway. There will be losers and winners. And attempting to decipher which individual companies will lose and which will win is mostly a loser's game. Here's a thought: Instead of trying to be a hero by handpicking health care stocks, why not use diversified health care ETFs? They're still one of the smartest ways to capitalize on the evolving dynamics within this sector.

Reprints Discuss this story
This is where the comments go.