FMD Capital Management

How Healthcare ETFs Can Strengthen Your Portfolio

Written by David Fabian, February 11th, 2014

Healthcare has been on a major hot streak for well over a year now.  The combination of our aging population and strong demand for medical services has boosted the prices of healthcare stocks to fantastic levels.  When you think about the path of Obamacare, shifting demographic trends, and future innovation in drugs and procedures, it becomes clear that the outlook in this sector is very bright.

There are a variety of ways that you can capitalize on the rising trend of healthcare companies in this country.  Many people prefer to choose individual stocks because of their research and belief in a specific businesses outlook.  My preferred choice is to select a basket of stocks that offer access to a wide swath of industries that are focused in multiple areas.

There is no easier way to do this than through a low-cost exchange-traded fund.  However, picking the right ETF is all about understanding the underlying holdings, fees, and index construction in order to successfully navigate this crowded field.  It is important to understand what you own and how it will adapt to changing market conditions.

The most widely held ETF in this sector is the Healthcare Select Sector SPDR (XLV) which contains 56 large-cap companies primarily engaged in the pharmaceuticals, biotechnology, and medical provider fields.  XLV controls nearly $9 billion in total assets and charges a modest expense ratio of just 0.16%.  In 2013, this ETF gained 41.21% which handily beat the 32.13% return of the SPDR S&P 500 ETF (SPY).

XLV is probably one of the easiest ways to get broad-based exposure to the healthcare sector in a very liquid vehicle.  While the ETF is not overly diversified, it does give you exposure to a variety of industries within the healthcare sector that offer their own unique characteristics.  Over the last year this sector has been increasingly low in volatility and high in total return.

More aggressive investors may be interested in honing in on an industry group like biotech stocks that have been a rocket ship of momentum.  The iShares NASDAQ Biotechnology ETF (IBB) has over $5 billion invested in 123 companies focused on developing new innovative pharmaceutical and medical devices.  In 2013, this ETF returned a whopping 65.47% gain on the back of stellar performance from some of its largest underlying holdings.  Last year wasn’t necessarily a fluke either, IBB boasts 3-year annualized returns of 34.67% and 5-year annualized returns of 26.52%.

Biotechnology stocks are known to be more volatile because of their hit-or-miss business models which often times lead to periods of strong outperformance or underperformance.  Often times their stocks are affected by factors such as FDA approval, drug trials, R&D costs, and other unforeseen events.  However, they can also lead to big profits when new products are developed and successfully tested.

Another interesting ETF that treads the line between passive and active investing in the healthcare field is the First Trust Health Care AlphaDEX Fund (FXH).  This ETF is a “smart beta” strategy that screens healthcare stocks for book value, cash flow, and return on assets.  It then weights the components according to their scores in these categories.  Because the index is rebalanced quarterly, it is being refreshed with companies that have strong fundamental business characteristics.

FXH currently has nearly $2 billion invested in 76 companies.  One of the benefits of this strategy is that you get a broader subset of healthcare stocks that include more small and mid-cap companies as opposed to just large-cap names.  The total return of this ETF in 2013 was 47.55% which bested XLV despite having a higher expense ratio of 0.70%.

A quick look at the charts above shows that these ETFs have been aggressively bought on nearly every dip down to their 50-day moving average.  In addition, the recent push higher has brought them all the way back in striking distance of new all-time highs. This may not be the optimal point to establish new positions given the lofty heights that they have reached.

I would not be hesitant to add to this sector on a modest pullback that gives you a better opportunity for long-term success.  In addition, I recommend that you implement a stop loss or sell discipline to guard against the potential of a protracted decline.  Stocks have certainly been more volatility in 2014 than they were last year, but that also means that there may be opportunities to put money to work at more advantageous prices.

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