Playing Defense With A Top Healthcare ETF

| About: Health Care (XLV)

By Robert Goldsborough

Back in June, the U.S. Supreme Court ruled that the Affordable Care Act's individual mandate provision is constitutional. And earlier this month, the American people effectively weighed in as well, giving the president another four years in office. That will allow continued implementation of the Patient Protection and Affordable Care Act, or PPACA.

Even before the election, it was evident investors felt that the PPACA is here to stay. The stock prices of healthcare companies largely have kept up with--or outpaced--the rest of the market and have not reacted meaningfully to either the Supreme Court's decision or the results of the election. Had investors felt, by contrast, that the entire law would be overturned, we would have expected to see negative investor sentiment (investors hate uncertainty) and compressed earnings multiples across the sector.

With those two hurdles cleared, what's next for the healthcare sector? At this point, healthcare firms await the resolution of a federal budget impasse involving sequestration and likely automatic budget cuts (which could range from 2% to Medicare to as much as 8.2% to non-defense non-discretionary spending such as National Institutes of Health funding). We think the market is already incorporating such cuts into healthcare firms' share prices, but it's possible that greater (or fewer) cuts could have a modest impact on healthcare firms.

The healthcare sector also is enjoying a minor tailwind as the number of uninsured patients has started to decline slightly. The number of uninsured patients still is high--more than 17% of the population--but the decline, which comes after a long period of growth in uninsured patients, is encouraging. And the full implementation of PPACA over the next several years should help boost commercial volumes, which are the most preferred reimbursements (instead of Medicare and Medicaid).

For investors seeking a defensive tilt to a broad-based portfolio, an exchange-traded fund devoted to healthcare companies makes a lot of sense. Investors seeking high-quality North American healthcare companies should consider Health Care Select Sector SPDR (NYSEARCA:XLV). Given the sector's lack of sensitivity to the overall economic climate, investors desiring a defensive tilt may find this ETF to be a suitable satellite holding. Keep in mind that this fund's holdings comprise 100% of the healthcare exposure in the S&P 500, implying that owning this ETF alongside a broad-market fund like SPDR S&P 500 (NYSEARCA:SPY) means that investors effectively are overweighting (or doubling up on) their healthcare exposure. In November 2012, healthcare represented about 12% of the S&P 500 Index.

While XLV offers exposure to many industries in the healthcare sector, Big Pharma firms comprise almost 51% of the fund's assets. XLV's heavy exposure to Big Pharma shouldn't--by itself--deter investors, as the subsector weightings are representative of the entire healthcare industry.

Fundamental View
Historically defensive and non-cyclical, the healthcare sector is seeing added growth from an aging America. Demand is relatively stable because people require treatment regardless of the economy, and baby boomers needing greater treatment make for a compelling secular-growth story. An aging population bodes well for the industry's future prospects because the majority of people's lifetime medical costs are spent in their final few years. The healthcare sector has hit a lull in recent years, as some key blockbuster drugs have lost exclusivity, prompting a blitz of competition from generic drug firms.

With healthcare reform unlikely to be repealed, investors need to note its impact on the industry. Morningstar's equity analysts believe that healthcare reform will weigh on industry earnings per share by as much as 5% a year during the first few years of reform, followed by EPS accretion of about 2% a year beginning in 2014, once cost pressures are mitigated by a greater number of patients insured.

Many Big Pharma and biotech companies are seeing the same early effects from reform: Higher rebates for Medicaid patients (bad for biotechs because companies see lower net prices for drugs), and now, the firms are being hit by an industry tax. These drug companies will also be responsible for covering half of the "doughnut hole" costs, which is the difference between Medicare's prescription drug program's initial coverage limit and the catastrophic coverage threshold. The doughnut hole isn't as big of an issue for a lot of biotech firms as it is for Big Pharma because the doughnut hole relates to Medicare Part D drugs, and many biologics are Part B drugs. This dynamic fundamentally benefits the biotech sector because drugs reimbursed as medical benefits are Part B and not Part D drugs. This means that, because of lower out-of-pocket costs, patients don't have to go through the doughnut hole and perhaps are more likely to start or continue therapy despite the economy.

Managed-care organizations are net healthcare reform losers, but the impact on them is much smaller than feared. MCOs will be hurt by Medicare Advantage reimbursement reductions--which probably would have occurred even without reform--and by explicit limits on medical cost ratios (the percentage of premium revenue spent on medical care). MCOs should benefit from increased Medicaid and individual insurance enrollment.

Hospital operators who are seeing admissions growth as baby boomers age will not benefit from healthcare reform. By law, hospitals must treat emergency patients who can't or don't pay their medical bills, costing hospitals millions per year in charity care and bad debt expense. Many of the 32 million uninsured individuals enrolling in Medicaid and insurance exchanges by 2014 will require health care. However, any benefit from fewer uninsured patients will be offset by higher exposure to the federal government and cuts to Medicare Advantage. Medicare and Medicaid reimbursements often make up much of a hospital's payer mix. And as uninsured patients become enrolled in Medicaid, many hospitals will find the government determining a majority of their reimbursement rates.

Also, Medicare Advantage cuts will hurt profitability. First, many Medicare Advantage patients likely will shift to private supplemental insurance. Second and more important, because private-payer reimbursement rates are benchmarked to Medicare, Medicare Advantage cuts will mean that private payers will follow suit by cutting reimbursement rates, particularly affecting the outpatient services that health-service providers historically have used to gain better margins from higher private-payer reimbursements.

In our view, an ETF can help healthcare investors diversify away company-specific risks. Granted, all healthcare firms face the risk of Congress changing the rules--that is, Medicare reimbursement, nationalized healthcare, or stricter FDA guidelines--which could potentially hurt all stocks here to some degree. But by buying at a discount to the portfolio's intrinsic value, investors can mitigate even this risk.

Morningstar's equity analysts show XLV to be trading at 93% of its fair value. That compares with the S&P 500 as a whole, which trades at 91% of fair value.

Portfolio Construction
This ETF owns the 52 healthcare companies in the S&P 500, weighted according to market cap. These include firms focused on drugs (both Big Pharma and biotech), healthcare equipment and supplies, hospitals, medical devices, and health insurers. Because the index draws its constituents from the broader S&P 500, it has an inherent quality screen. In fact, all of the top 10 holdings sport wide moat ratings. About 65% of assets are invested in wide-moat stocks, and 96% of assets are invested in companies with narrow or wide moats. S&P 500 holdings have to meet the standards of the S&P's selection committee, and this includes profitability and status as a leading U.S. company. Because the criteria eliminate foreign healthcare companies, the index excludes international healthcare behemoths such as Novartis (NYSE:NVS), GlaxoSmithKline (NYSE:GSK), Roche, and Sanofi (NYSE:SNY). That said, we'd note that most of the firms included here are large multinational firms with businesses spanning the globe.

The fund's 0.18% expense ratio makes it one of the cheapest healthcare sector ETFs available.

Vanguard Health Care ETF (NYSEARCA:VHT) provides similar exposure to the sector (but has more holdings--293 in total) and charges a low 0.19% expense ratio. Fully 100% of XLV's holdings are held in VHT, and the funds' performance correlation over the past five years has been an extremely high 99%. Another alternative would be iShares Dow Jones US Healthcare (NYSEARCA:IYH) (0.47% expense ratio), which holds 115 stocks and sports a 99% performance correlation with XLV over the past five years.

Investors seeking some international flavor for their healthcare exposure should consider iShares S&P Global Healthcare (NYSEARCA:IXJ) (0.48%), as it invests almost 38% of assets in foreign-domiciled firms. Those seeking exposure only to those firms domiciled outside North America might take a look at SPDR S&P International Health Care Sector ETF (NYSEARCA:IRY) (0.50%).

Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.