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The Health Care sector ranks third out of the ten sectors as detailed in my sector rankings for ETFs and mutual funds. It gets my Neutral rating, which is based on aggregation of ratings of 21 ETFs and 91 mutual funds in the Health Care sector as of October 9, 2012. Prior reports on the best and worst ETFs and mutual funds in every sector and style are here.

Figures 1 and 2 show the five best and worst-rated ETFs and mutual funds in the sector. Not all Health Care sector ETFs and mutual funds are created the same. The number of holdings varies widely (from 20 to 297), which creates drastically different investment implications and ratings. The best ETFs and mutual funds allocate more value to attractive-or-better-rated stocks than the worst ETFs and mutual funds, which allocate too much value to neutral-or-worse-rated stocks.

To identify the best and avoid the worst ETFs and mutual funds within the Health Care sector, investors need a predictive rating based on (1) stocks ratings of the holdings and (2) the all-in expenses of each ETF and mutual fund. Investors need not rely on backward-looking ratings. My fund rating methodology is detailed here.

Investors seeking exposure to the Health Care sector should buy one of the Attractive-or-better rated ETFs or mutual funds from Figures 1 and 2.

Get my ratings on all ETFs and mutual funds in this sector on my free mutual fund and ETF screener.

Figure 1: ETFs with the Best & Worst Ratings - Top 5

* Best ETFs exclude ETFs with TNA's less than 100 million for inadequate liquidity.

Sources: New Constructs, LLC and company filings

ProShares Ultra Health Care (RXL), Rydex S&P Equal Weight Health Care ETF (RYH) and PowherShares Dynamic Healthcare (PTH) are excluded from Figure 1 because their total net assets (TNA) are below $100 million and do not meet our liquidity standards.

Figure 2: Mutual Funds with the Best & Worst Ratings - Top 5

* Best mutual funds exclude funds with TNA's less than 100 million for inadequate liquidity.

Sources: New Constructs, LLC and company filings

Seven mutual funds are excluded from figure 2 because their total net assets are below $100 million and do not meet our liquidity standards.

Health Care Select Sector SPDR (XLV) is my top-rated Health Care ETF and Vanguard World Funds: Vanguard Health Care Index Fund (VHCIX) is my top-rated Health Care mutual fund. Both earn an Attractive-or-better rating.

SPDR S&P Biotech ETF (XBI) is my worst-rated Health Care ETF and Fidelity Advisors Series VII: Fidelity Advisor Biotechnology Fund (FBTAX) is my worst-rated Health Care mutual fund. Both earn a Dangerous-or-worse rating.

Figure 3 shows that 79 out of the 342 stocks (over 55% of the total net assets) held by Health Care ETFs and mutual funds get an Attractive-or-better rating. However, only seven out of the 91 Health Care mutual funds (less than 3% of total net assets) get an Attractive-or-better rating. That is a terrible percentage compared to ETFs. Five out of the 21 Health Care ETFs (45% of total net assets) receive an Attractive-or-better rating. Although only five investment worthy funds exist, investors are allocating 45% of their value to these high quality ETFs.

The takeaway is: mutual fund managers allocate too much value to poor quality stocks and do not justify their costs.

Figure 3: Health Care Sector Landscape For ETFs, Mutual Funds and Stocks

Sources: New Constructs, LLC and company filings

As detailed in "Cheap Funds Dupe Investors," the fund industry offers many cheap funds but very few funds with high-quality stocks, or with what I call good portfolio management.

Investors need to tread carefully when considering Health Care ETFs and mutual funds, as only five ETFs and seven mutual funds are worth buying. As highlighted in figure 4 below, ETF investors are doing a great job at identifying quality investments and allocating capital accordingly.

Amgen Inc. (AMGN) is one of my favorite stocks held by Health Care ETFs and mutual funds and earns my Very Attractive rating. AMGN has generated a return on invested capital (ROIC) greater than its weighted average cost of capital (WACC) every year in my model. In fact, AMGN's ROIC in 2011 places it in the top 86th percentile of all Russell 3000 companies. In spite of strong past performance, the market has low expectations for AMGN. The current stock price (~$86.04) implies that future after-tax profits (NOPAT) will decrease permanently by 20%. Strong past performance and low future expectations are a recipe for a great long candidate.

Valeant Pharmaceuticals International, Inc. (VRX) is one of my least favorite stocks held by Health Care ETFs and mutual funds and earns my Very Dangerous rating. For the past three years, Valeant has earned an ROIC below its WACC, which means the company is destroying shareholder value. Not only has Valeant been a poor steward of capital, its current stock price implies dramatic improvement in profits. To justify today's price, the company must grow revenues at over 25% compounded annually for the next 10 years. That is an awful rich valuation for a company with such an unprofitable past.

Figures 4 and 5 show the rating landscape of all Health Care ETFs and mutual funds.

Our sector rankings for ETFs and mutual funds report ranks all sectors and highlights those that offer the best investments.

Figure 4: Separating the Best ETFs From the Worst ETFs

Sources: New Constructs, LLC and company filings

Figure 5: Separating the Best Mutual Funds From the Worst Mutual Funds

Sources: New Constructs, LLC and company filings

Review my full list of ratings and rankings along with reports on all 21 ETFs and 91 mutual funds in the Health Care sector.

Disclosure: I receive no compensation to write about any specific stock, sector or theme.

Source: Best And Worst ETFs And Mutual Funds: Healthcare Sector