As the 78 million baby boomers reach retirement age, they will place increased demand on the healthcare system. General consensus is that the aging population will bode well for the healthcare stocks since a majority of medical costs occur after a person retires. On the minus side, some pharmaceutical companies are under pressure as their blockbuster drugs lose patent protection. The Affordable Care Act has also increased uncertainty in how regulations will be enforced. Thus, investing in healthcare funds presents both unique opportunities and risks.
My objective in this article is to analyze the risk-to-reward characteristics of this asset class. I wanted to analyze performance over a complete market cycle, so I restricted my analysis to funds that were launched prior to October 12, 2007 (the start of the bear market). I required at least a moderate liquidity, with an average volume of at least 50,000 shares trading each day. I also did not include leveraged or inverse funds in this analysis.
The healthcare sector is very broad, encompassing pharmaceutical companies (called big pharma), biotechnology (biotech), health care equipment, hospitals, medical devices, and health insurers. To put the performance in better perspective, I first reviewed ETFs that covered the entire gamut of the industry and then looked at some of the sub-sectors.
The overall healthcare ETFs are:
- Health Care Select SPDR (XLV). This EFT trades over 8 million shares each day, making it the most liquid healthcare fund. It consists of 53 companies with big pharma consuming almost 50% of the total assets. The largest holdings are Johnson & Johnson (JNJ) at almost 13% of total assets, followed by Pfizer (PFE) at about 12%. This ETF does not have any foreign domiciled health care companies.
- Vanguard Health Care (VHT). This ETF consists of 295 cap-weighted holdings with more than half of the assets contained in the top ten holdings. For this ETF, JNJ comes in at almost 11% of assets and PFE at about 10%. VHT is about 95% correlated with XLV.
- iShares Dow Jones US Health Care (IYH). This ETF has 114 stocks with big pharma plus biotech accounting for about two thirds of the assets. This ETF is also about 95% correlated with XLV, with the top two holdings being JNJ and PFE.
- iShares S&P Global Health Care (IXJ). Unlike the other funds, about 39% of the 86 holdings are in foreign companies. JNJ and PFE are still the largest holdings, but account for only about 7% to 8% each of the total assets. Another top holding is Switzerland based Novartis (OTCQB:NVSEF), accounting for 6.6% of the assets. Even with the non-U.S. holdings, IXJ is still 90% correlated with XLV.
- First Trust Health Care AlphaDex (FXH). This ETF tracks a StrataQuant index that uses a proprietary stock selection algorithm based on ranking growth and value parameters. There are a total 70 holdings. Unlike other ETFs, over 70% of the holdings are mid-cap with only 13% in biotech companies and 10% in big pharma. The index is re-evaluated quarterly and is 80% correlated with XLV.
To assess the risks and rewards of these healthcare ETFs, I plotted the annualized rate of return in excess of the risk free rate (called Excess Mu on the charts) versus the volatility of each ETF. The results are shown in Figure 1. The Smartfolio 3 program (smartfolio.com) was used to generate this chart. The overall sector ETFs are distinguished by the "green diamonds" on the charts. For reference, the risk versus reward of the SPY (S&P 500) is shown as a "black dot." As seen from the figure, these ETFs have had exceptional performance since 2007, generating returns greater than SPY with less risk.
Figure 1: Risk vs. Reward for Healthcare ETFs over a 5.5 year cycle
Continuing the analysis, I focused on the sub-sectors of the overall healthcare space. The "big pharma" subsector is represented by the following ETF:
- PowerShares Dynamic Pharmaceuticals (PJP). This ETF avoids healthcare services and medical device companies. It is a "quant" fund that uses a 50 factor proprietary model to rank stocks in terms of capital appreciation potential. The fund contains 30 stocks. This is a market cap weighted fund but because of its construction, the largest holding seldom exceeds 5%. It is rebalanced quarterly. The risk reward associated with this ETF is shown as an "orange dot" on the Figure.
For the biotech subsector, I analyzed 3 funds that are summarized below. On average, it takes 10 to 15 years to get regulatory approval for a new drug at a cost of about $1 billion. To make matters worse, only about 20% that have success in early trials actually make it to the market. Thus, this subsector has a lot of promise but it is also highly volatile. The risks-rewards associated with these biotech ETFs are plotted as "red dots."
- iShares Nasdaq Biotechnology (IBB). This ETF consists of 120 stocks, with over 75% in the biotech arena. The top holdings are Regeneron Pharmaceuticals (REGN), Gilead Sciences (GILD), and Amgen (AMGN).
- SPDR S&P Biotech (XBI). This ETF consists of 49 equally weighted companies. About half of the holdings are "early stage development" firms that are focused on pure research with no drugs on the market yet. This emphasis on small-cap stocks has made XBI the most volatile fund of the group.
- First Trust NYSE Arca Biotech Index (FBT). This is an equal-weight ETF consisting of 20 U.S. biotech companies. It includes both mid-cap and small-cap firms, and like XBI, is very volatile. FBT is 88% correlated with XBI and 72% correlated with XLV.
The last ETF that I considered was in the medical devices niche. This subsector manufactures hardware that can be implanted, such as knee replacements and cardiac devices. There was only one EFT that met my selection criteria:
- iShares Dow Jones US Medical Devices (IHI). This is a cap-weighted ETF with 39 U.S.-based companies. The top ten holdings make up over 60% of this fund. The largest holding is Medtronic (MDT), which represents about 11% of the total portfolio. This EFT is denoted by a "blue dot" on the Figure.
To round out the analysis, I included the one closed end fund that met my liquidity criteria:
- H&Q Healthcare Investors (HQH). This fund has 94 holdings and focuses on both biotech and big pharma. It has a nice yield of over 7% and currently sells for a small discount to net asset value. It is designated by a "purple dot" on the Figure.
As seen from the figure, there is a wide range of returns and volatilities. To assess if the reward is worth the increased risk, I calculated the Sharpe Ratio for each fund. The Sharpe Ratio is a metric developed by Nobel laureate William Sharpe that measures risk-adjusted performance. It is calculated as the ratio of the excess return over the volatility (the reward-to-risk ratio if you measure "risk" by the volatility). It is a good way to compare peers to assess if higher returns are due to superior investment performance or from taking additional risk. On the Figure, I also plotted a red line that represents the Sharpe Ratio of the SPY. If an asset is above the line, it has a higher Sharpe Ratio than the S&P 500. Conversely, if an asset is below the line, the reward-to-risk is worse than the SPY.
Figure 1 provides some interesting observations. Since 2007, the healthcare ETFs are all above the red line, meaning that they have reward-to-risk better than the S&P 500. The quant fund, PJP, has the best Sharpe Ratio and IHI the worst. The closed end fund HQH is the second best performer of the group. As expected, the biotech funds exhibited high volatility but rewarded the investors with excellent returns. The entire-sector ETFs (green diamonds) tended to be grouped together with a relatively low Sharpe Ratio (when compared to the other healthcare funds). The "quant" fund FXH has the best Sharpe Ratio among these entire-sector funds.
To see if the outperformance has continued into the recent past, I also plotted the same ETFs with a 3 year look-back period. These plots are shown in Figure 2. Even though the SPY has been in a rip roaring bull market over this period, the healthcare ETFs have done even better (with the exception of IHI). PJP and HQH have continued their dominance in this asset class.
Figure 2: Risk vs Reward of Healthcare Funds over past 3 years
The bottom line is that healthcare funds have been an excellent choice for perking up the reward-to-risk attributes of your portfolio.