A Look at the Best Healthcare Sector ETFs

Our top picks for healthcare sec­tor ETFs are Biotech HOLDRS (BBH) and Phar­ma­ceu­ti­cal HOLDRS (PPH). We also rate the invest­ment merit of the top-9 healthcare sec­tor ETFs.

Per our first quarter 2011 review of U.S. Equity Sec­tor ETFs, the healthcare sec­tor is one of only three sec­tors that gets our “Attrac­tive” rat­ing. In addi­tion, this sec­tor has more “very attractive rated” ETFs than any other sec­tor. Some of our top-rated stocks in this sec­tor are Eli Lilly (LLY), United Health Care (UNH) and Bris­tol Myers Squibb (BMY). Fig­ure 2 shows how the healthcare sector’s stocks and the mar­ket value attrib­uted to them stack up under the micro­scope of our risk/reward rat­ing system.

Fig­ure 1: Health Care Sec­tor – Cap­i­tal Allo­ca­tion and Hold­ings by Risk/Reward Rating

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Sources: New Con­structs, LLC and com­pany filings

The healthcare sec­tor has only 10% of its value invested in dangerous-or-worse-rated stocks and 46% of its value invested in attractive-or-better-rated stocks. Rel­a­tively low allo­ca­tion to dangerous-or-worse-rated stocks enables the healthcare sec­tor to earn our attrac­tive over­all risk/reward rating.

The key take­away here is that the healthcare sec­tor offers both good and poor invest­ment oppor­tunities. The value of each ETF is derived from its con­stituents, so ETFs that over­weight attractive-or-better-rated stocks, like BBH and PPH, are great invest­ment oppor­tu­ni­ties while ETFs that over­weight neutral-or-worse-rated stocks should be avoided.

When ana­lyz­ing healthcare sec­tor ETFs, we started by iden­ti­fy­ing those ETFs with accept­able struc­tural integrity as mea­sured by XTF, an ETF research firm. We chose the nine ETFs whose XTF rat­ing was above the sec­tor aver­age XTF rating.

Fig­ure 2: Health Care ETFs With Accept­able Struc­tural Integrity

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Sources: New Con­structs, LLC; XTF and com­pany filings

Fig­ure 2 shows clearly that not all healthcare ETFs are made the same. Dif­fer­ent ETFs have mean­ing­fully dif­fer­ent num­bers of hold­ings and, there­fore, dif­fer­ent allo­ca­tions to hold­ings. Given the dif­fer­ences in hold­ings and allo­ca­tions, these ETFs will likely per­form quite differently.

After deter­min­ing the struc­tural integrity, we ana­lyzed the invest­ment merit of each ETF based on how it allo­cated value to each stock it held. Fig­ure 4 shows how the 12 healthcare sec­tor ETFs stack up ver­sus each other and the over­all sec­tor based on their over­all risk/reward rat­ings and the allo­ca­tion of their hold­ings by rating.

Fig­ure 3: Invest­ment Merit Based on Hold­ings and Allocations

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Sources: New Con­structs, LLC; XTF and com­pany filings

Attrac­tive ETFs

BBH, PPH, XLV, IHF, VHT, FXH, IHI and IYH - these eight ETFs earn an Attractive-or-Better Over­all Risk/Reward rat­ing and there­fore, are the only healthcare ETFs we rec­om­mend. Our top picks from this group are BBH and PPH.

Neu­tral ETFs

PRN allo­cates its value in a way that earns it a Neu­tral Over­all Risk/Reward rat­ing. We rec­om­mend investors buy the very attrac­tive and attrac­tive stocks in this sec­tor before buy­ing any of the healthcare ETFs except those we rec­om­mend. Fig­ure 5 con­trasts the dif­fer­ences in invest­ment merit between PRN, BBH and the over­all sector.

Dan­ger­ous ETFs

This report does not include any Dangerous-or-Worse rated ETFs.

Bench­mark Comparisons

Sec­tor Benchmark

BBH out­per­forms the over­all healthcare sec­tor in qual­ity of earn­ings rat­ings. BBH earns a Very Attrac­tive Eco­nomic vs. Reported Earn­ings rat­ing because its eco­nomic earn­ings are pos­i­tive and ris­ing while the sector’s eco­nomic earn­ings are pos­i­tive and decreas­ing. BBH also out­per­forms with an ROIC of 20.4%, earn­ing it a Very Attrac­tive rat­ing, com­pared to the sector’s ROIC of 11.7%.

BBH also out­per­forms the sec­tor in val­u­a­tion rat­ings. BBH has a Price-to-EBV of .6, earn­ing it a Very Attrac­tive rat­ing, and a GAP of 4 years com­pared to the over­all sector’s Price-to-EBV of 1.0 and a GAP of 11 years.

Fig­ure 4: BBH – Risk/Reward Rating

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Sources: New Con­structs, LLC and com­pany filings

Fig­ure 5: Health Care Sec­tor – Risk/Reward Rating

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Sources: New Con­structs, LLC and com­pany filings

BBH more effec­tively allo­cates cap­i­tal to attractive-or-better-rated stocks than the over­all healthcare sec­tor. Per Fig­ure 4 above, BBH allo­cates 76.6% of its value to Very Attractive-rated stocks while the sec­tor only allo­cates 33.08%. How­ever, BBH allo­cates 17.13% of its value toward dangerous-or-worse-rated stocks com­pared to the sector’s dangerous-or-worse weight­ings of 10.18%.

Mar­ket Benchmark

BBH out­per­forms the S&P 500 in qual­ity of earn­ings rat­ings. BBH earns a Very Attrac­tive Eco­nomic vs. Reported Earn­ings rat­ing because its Eco­nomic Earn­ings are pos­i­tive and ris­ing while the S&P 500’s Eco­nomic Earn­ings are pos­i­tive and decreas­ing. Although both BBH and the S&P 500 earn a Very Attrac­tive ROIC rat­ing, BBH’s ROIC of 20.4% edges out the S&P 500’s ROIC of 18.2%.

BBH also out­per­forms the S&P 500 in val­u­a­tion rat­ings. BBH has a Price-to-EBV of .6, earn­ing it a Very Attrac­tive rat­ing, and a GAP of 4 years com­pared to the S&P’s Price-to-EBV of 1.5 and a GAP of 26 years.

Fig­ure 6: BBH – Risk/Reward Rating

Sources: New Con­structs, LLC and com­pany filings

Fig­ure 7: S&P 500 – Risk/Reward Rating

Sources: New Con­structs, LLC and com­pany filings

BBH allo­cates cap­i­tal more effec­tively than the S&P 500. Per Fig­ure 3 above, BBH allo­cates 76.6% of its value to Very Attractive-rated stocks while the S&P 500 only allo­cates 21.47%. BBH also only allo­cates 17.13% of its value toward dangerous-or-worse-rated stocks com­pared to the S&P 500’s dangerous-or-worse weight­ings of 24.51%.

Method­ol­ogy

This report offers rec­om­men­da­tions on healthcare sec­tor ETFs and bench­marks for (1) investors con­sid­er­ing buy­ing healthcare sec­tor ETFs and for (2) com­par­ing indi­vid­ual ETFs to the healthcare sec­tor and the S&P 500. Our analy­sis is based on aggre­gat­ing results from our mod­els on each of the com­pa­nies included in every ETF and the over­all sec­tor (415 com­pa­nies) based on data as of 04/05/11. We aggre­gate results for the ETFs in the same way the ETFs are designed. Our goal is to empower investors to ana­lyze ETFs in the same way they ana­lyze indi­vid­ual stocks.

To make an informed ETF invest­ment, investors must consider:

1) The struc­tural integrity of the ETF and its abil­ity to ful­fill its stated objec­tive. We use XTF, an ETF research firm, to find the top 12 ETFs with the best struc­tural integrity rating.

2) The qual­ity of the ETF’s hold­ings. We deter­mine an ETF’s qual­ity using our over­all risk/reward rat­ing system.

Given the suc­cess of our Rat­ing sys­tem for indi­vid­ual stocks, we believe its appli­ca­tion to groups of stocks (i.e. ETFs and funds) helps investors make more informed ETF and mutual fund buy­ing deci­sions.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.