PowerShares FTSE RAFI Healthcare: Big Bets on Dow Dogs

While the PowerShares FTSE RAFI Health Care fund (PRFH) has experienced a recent leap in momentum, this move may not come as a surprise to many health care investors. PRFH has jumped 20 spots, from 61 to 41, on our PowerShares Momentum Tracker Sector Momentum Table in the last month, a testament to the historical appeal of the health care sector in difficult market times.

Spurred by news and earnings from top components such as Amgen (AMGN), PRFH returned 5.64% for a one-month period ending July 24, while the S&P 500 fell 3.01% for the same period. After a difficult start to 2008, PRFH rebounded solidly in July, yet the fund remains down nearly 13% for the year.

PRFH seeks to replicate the FTSE Research Affiliates Fundamentals Health Care Sector Index, which is designed to track the performance of the largest U.S. health care equities. Rather than just picking stocks based on market cap, however, PRFH uses four fundamental measures of firm size to select its components: book value, cash flow, sales and dividends.

While it has garnered favor with many ETF investors, the fundamental indexing approach has sparked debate among experts. ETFs with a fundamentally weighted index have a much more subjective methodology than many of their peers that simply track such large indices as the S&P 500.

As new “actively managed ETFs” begin hitting the market, though, the idea of a fundamentally weighted index may seem more familiar than before. With the credit crunch tugging at global economies, some investors are actively seeking funds that have less correlation to large indices—a phenomenon that may boost the popularity of ETFs like PRFH.

Both oil and financials have shed value in the last couple of weeks, and good news from big pharmaceuticals has caused many investors to seek shelter in health care. Amgen, PRFH’s sixth-largest holding, experienced a boost early in the week as the company announced higher-than-expected earnings. Another boon to Amgen’s price was the news of a patent lawsuit filed against pharma rival Barr. The suit, filed Tuesday, sought to prevent Barr from releasing a generic version of Amgen’s Sensipar, which generated $377 million in sales for Amgen in the U.S. for the 12-month period ending in May. News of the lawsuit bolstered Amgen’s price, while Barr’s stock slipped in Tuesday’s trading.

PRFH also includes components that provide cushioning in the hit-or-miss world of drug patents. Johnson & Johnson (JNJ), PRFH’s second-largest component, draws significant benefits from its strong consumer unit. In 2006, Pfizer (PFE), PRFH’s top holding, sold its consumer unit to Johnson & Johnson in a $16.6 billion transaction. Household names like Listerine and Sudafed were added to the JNJ roster during the transaction.

Since we last profiled PRFH in January 2007, the fund’s fundamental methodology has dictated one major change in its top ten holdings: Medco Health Solutions, Inc. (MHS) has taken the place of Schering-Plough (SGP). Schering-Plough still remains a strong member of PRFH’s roster, but it only makes up 1.65% of the portfolio instead of the 3.21% it held at our last review. This shift is a good example of PRFH’s methodology at work—Medco has outperformed Schering-Plough by more than 50% in the last two years and has earned a larger allocation over time.

Two of PRFH’s top components, Pfizer and Merck (MRK), have also been named in the popular “Dogs of the Dow” strategy.* Popularized in the early 1990s by Michael O'Higgins, this strategy involves picking the highest dividend yielding stocks in the Dow, with the assumption that large blue chips will not change dividends to reflect market conditions. In difficult market periods, investing in stocks with high dividends, such as Pfizer and Merck, can prove to be profitable. As market conditions improve, the prices of “Dow Dogs” often rise to reflect fundamental value. Components such as Pfizer and Merck, with dividend yields of 6.78% and 4.65%, respectively, may help to sweeten PRFH’s performance if market conditions improve later this year.

While PRFH’s net assets are relatively small, at $13.51 million, and trading is fairly light, the massive market caps of the underlying components should take the edge off investors’ concern. The top ten holdings of PRFH are some of the largest and most liquid in the industry, with an average market cap of $70 billion.**

As emerging economies increase production, a new middle class, demanding an increasing amount of consumer goods, is growing overseas. While the price of oil and financial institutions may remain in flux for the foreseeable future, the demand for pharmaceuticals and consumer items may help to boost the price—and popularity—of funds like PRFH.

*Source: Investopedia.com
**Source: PowerShares.com

Comments

[kkin365:]

Thanks for giving us the 10 top holdings.

2008 Aug 01 09:23 AM

[truthinvesting:]

nice article in my bargain bin thread those top 3 holdings are all my selections as well.

2008 Aug 02 04:09 PM