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The ETF Advisor: Prospects for Healthcare ETFs Better Than Those for Reform

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While the inability of Congress to form a consensus on how to change the current healthcare system seems to indicate a lack of appealing options for reform, investors are fortunate to have a wide variety of vehicles available to gain exposure to the healthcare sector, which seems poised for long-term growth.

In fact, healthcare is one of just three sectors that Standard & Poor’s Equity Strategy recommends investors overweight in their portfolios (the others are information technology and industrials), and S&P equity analysts have a positive outlook for the healthcare sector based on positive fundamental outlooks for the pharmaceutical, biotechnology, and managed care industries, which together represent about 75% of the sector.

There are about two dozen exchange traded funds that offer a wide variety of exposures to the sector, including broad-based, global, and leveraged ETFs, as well as those targeting individual industries.

Among broad-based healthcare ETFs, one choice is the Healthcare Select Sector SPDR Fund (XLV; overweight). It is the oldest, the largest, and the cheapest to own, and it holds the best one-year and three-year track record among all healthcare ETFs, whether broad-based or industry-specific. One drawback, however, is that because it tracks a market capitalization-weighted index, the fund’s three largest holdings are pharmaceutical manufacturers Pfizer [PFE ****], Johnson and Johnson [JNJ ****], and Merck [MRK ****]. Those companies feature prominently in healthcare ETFs targeting the pharmaceutical industry, as well as other large-cap or broad-market ETFs and mutual funds that are based on market capitalization -weighted indexes, so the potential for overlap with other holdings is large.

The SPDR S&P Pharmaceuticals ETF (XPH; marketweight) is another choice. With $83 million in assets, it is smaller than the iShares Dow Jones US Pharmaceutical Index Fund (IHE; overweight), but it tracks an equal-weighted index, and thus has half the allocation to the big three pharma companies than the iShares fund. With 25 holdings, each company represents about 4% of the fund, which is rebalanced quarterly. It has also outperformed other pharmaceutical ETFs over the past one- and three-year periods and has the lowest annual expense ratio of the group.

Focused Healthcare ETFs

Investors have long held a soft spot in their hearts for biotechnology companies, With $1.5 billion in assets, the iShares Nasdaq Biotechnology Index Fund (IBB; overweight) is the category leader, and its 126 holdings make it far more diversified than other biotech ETFs. While its diversification has cause its performance to lag other more concentrated biotech ETFs over the past one- and three-year periods, its combination of low costs and highly ranked holdings make it the only biotech ETF with an overweight recommendation from S&P Equity Research.

Other healthcare ETFs target global companies as well as the medical device and healthcare providers/services subsectors. Most of the global funds have failed to attract a large asset base–the exception being the iShares S&P Global Healthcare Sector Index Fund (IXJ; overweight), which has 62% of its assets in U.S. companies–and S&P equity analysts have a neutral outlook for the healthcare equipment industry over the next 12 months. The iShares Dow Jones U.S. Healthcare Providers Index Fund (IYH; overweight) has about half its assets in the managed care sub-sector, for which S&P has a positive outlook, as well as one of the lowest expense ratios and highest one year returns of the entire group.

S&P Senior Financial Writer Vaughan Scully can be reached at [email protected]. Send him your ideas for ETF story topics.