My Attempt To Find The Best Healthcare Mutual Fund Since 2007

|
Includes: FBIOX, FPHAX, FSPHX, JAGLX, VGHCX, VHT, XLV
by: Dane Van Domelen
Summary

The healthcare sector has done tremendously well in recent years. My guess is it will continue to outperform the broader market.

There are many actively managed healthcare mutual funds, and quite a few seem to consistently outperform passive healthcare indexes.

The purpose of this article is to identify the best of those that were introduced before the 2007-2008 financial crisis, based on growth, alpha generation, MDD, Sharpe ratio, and fees.

Of the 23 funds examined, I favor FPHAX. It had the highest Sharpe ratio and smallest MDD, and consistently generates positive alpha and a Sharpe ratio greater than XLV's.

Background

I have been lucky enough to hold the Vanguard Health Care Fund Investor Shares (MUTF:VGHCX) for the past couple of years. Not only is the healthcare sector doing extremely well, but VGHCX has outperformed passive indexes like the Vanguard Health Care ETF (NYSEARCA:VHT) and the Health Care Select Sect SPDR ETF (NYSEARCA:XLV).

My guess is that healthcare stocks will continue to outperform the broader market, so I want to maintain an approximate 20% allocation to a healthcare fund. I have been very satisfied with VGHCX, but then again I haven't actually compared it with other actively managed healthcare funds. There are many such funds available, which is great because it means I have a decent shot at finding a fund that will perform even better going forward.

The purpose of this article is to compare historical performance of actively managed healthcare mutual funds. Of course, each investor gives certain weight to various aspects of a fund's performance, so I won't claim to identify the "best" healthcare fund. Rather, I will describe the process I used to identify the fund that is best for me.

Criteria

Actively managed mutual funds since 2007

I decided to keep the focus relatively narrow and look at actively managed mutual funds only. I have no preference for mutual funds over ETPs, but for the purposes of this article, I'm just looking at mutual funds. (Most healthcare ETPs seem to follow healthcare indexes anyway).

To avoid having my entire analysis centered on a raging bull market, I decided to only consider funds that have been around since before the 2007-2008 financial crisis. That allows for an assessment of how the funds perform during a market crash.

Fees and minimums

I am fairly tolerant of moderate fees in healthcare funds given their ability to generate very high returns. But I probably wouldn't go higher than 1.5%. Again, my starting point is VGHCX, which has done extremely well with an expense ratio of only 0.35%. It would take a substantial difference in historical performance to justify paying an extra 1.15% for a different fund.

I typically wouldn't invest in a fund with a front-end or back-end load. For this article, I excluded funds with front-end or back-end loads greater than 1%.

As for initial investment minimums, I'd prefer it to be less than $10,000.

Alpha generation

If you're paying for an actively managed fund, it better generate alpha for you. I'll be looking for funds that consistently generate alpha, using daily gains and XLV as a benchmark.

Raw returns not due to high beta

Raw returns is a primary consideration. I will give a lot of weight to total growth over the past 8.5 years.

I'll watch out for aggressive (high-beta) funds that have generated excellent raw returns mainly due to the recent bull market. High-beta funds typically do extremely well in strong markets and extremely poorly in weak markets.

Sharpe ratio

The Sharpe ratio is a useful metric for identifying funds with a good ratio of gains to volatility.

Data Source

I used Yahoo! Finance to obtain historical prices for each mutual fund (Adj Close column). All figures are originals.

Pool of Healthcare Mutual Funds

I used Morningstar to identify a list of healthcare mutual funds (full list here).

There were 128 total funds, but many were different classes of the same fund. When several classes were available, I picked the one with the lowest fees. I also excluded funds that were introduced more recently than Jan. 3, 2007, and funds that were not available for purchase through Vanguard.

The 23 funds that were ultimately included in the pool are listed below.

Table 1. List of healthcare mutual funds included in analysis.

Fund Ticker
Alger Health Sciences Fund C AHSCX
AllianzGI Health Sciences Fund Class D DGHCX
Fidelity Select Biotechnology Portfolio FBIOX
Fidelity Advisor Biotechnology Fund Institutional Class FBTIX
Fidelity Advisor Health Care Fund Institutional Class FHCIX
Fidelity Select Pharmaceuticals Portfolio FPHAX
Fidelity Select Medical Delivery Portfolio FSHCX
Fidelity Select Medical Equipment and Systems Portfolio FSMEX
Fidelity Select Health Care Portfolio FSPHX
Invesco Global Health Care Fund Investor Class GTHIX
ICON Healthcare Fund Class S ICHCX
Janus Global Life Sciences Fund Class T JAGLX
Live Oak Health Sciences Fund LOGSX
Kinetics Medical Fund No Load Class MEDRX
Putnam Global Health Care Fund Class Y PHSYX
T. Rowe Price Health Sciences Fund PRHSX
Rydex Health Care Fund Class Investor RYHIX
Rydex Basic Biotechnology Fund Class Investor RYOIX
Saratoga Health & Biotechnology Portfolio Fund Class Institutional SBHIX
Deutsche Health and Wellness Fund Class S SCHLX
BlackRock Health Sciences Opportunities Portfolio Service Shares SHISX
Schwab Health Care Fund SWHFX
Vanguard Health Care Fund Investor Shares VGHCX

15 Funds Consistently Generate Alpha

The figure below shows the estimated alpha and beta for each fund, based on daily gains since the beginning of 2007.

Alpha and beta estimates for healthcare funds from Jan. 3, 2007, to May 29, 2015.

An easy first cut is to drop ICHCX since it has had negative alpha since the beginning of 2007.

It's a bit hard to see, but the two overlaying each other are LOGSX and SBHIX, and the two right next to each other are SWHFX and DGHCX.

A few other notes from the figure:

  • FBIOX had the highest alpha overall at 0.0317, but it was not significantly greater than 0 (P = 0.13).
  • Alpha was significantly greater than 0 for only two funds: PRHSX, with alpha of 0.0251 (P = 0.048), and SHISX, with alpha of 0.0195 (P = 0.036).
  • There was a cluster of four funds in the top right corner with high alpha and relatively high beta in the 1.08-1.12 range.
  • VGHCX had the lowest beta at 0.8604, along with alpha of 0.0122 (P = 0.13).

In addition to positive alpha overall since 2007, a high-performing fund should generate alpha fairly consistently from one calendar year to the next. Seven funds (AHSCX, RYHIX, DGHCX, FBIOX, FBTIX, RYOIX, SCHLX) had negative alpha in four or more of the nine years and were thus excluded.

On the other end of the spectrum, two funds generated alpha in eight of the nine time periods (FPHAX, VGHCX), and four generated alpha in seven of the nine time periods (FHCIX, FSPHX, JAGLX, PRHSX).

If a fund was equally likely to have positive or negative alpha within a year, there would be a 9.0% chance of generating alpha in at least seven of nine years, and a 2.0% chance of generating alpha in at least eight of nine years. So the fact that six of the 23 funds (26.1%) generated alpha in at least seven years, and two of the 23 funds (8.7%) generated alpha in at least eight years, gives some indication that healthcare fund managers as a group are doing reasonably well. On the other hand, survivorship bias may also be at play here.

8 Funds Have Consistently Better Sharpe Ratio Than XLV

Using a similar approach as for alpha, a high-performing healthcare fund should have a better Sharpe ratio than XLV. This was not the case for three of the 15 remaining funds (FSHCX, GTHIX, MEDRX).

Four of the remaining 12 funds (FHCIX, LOGSX, PRHSX, SBHIX) had a worse Sharpe ratio than XLV in at least four of nine years, and were thus excluded.

Raw Returns and Maximum Drawdown

I haven't even mentioned raw returns or drawdowns yet, so let's see how these metrics looked for the remaining eight funds. The next figure shows each fund's maximum drawdown from Jan. 2007 to June 2009 and its compound annual growth rate from July 2009 to May 2015, in hopes of identifying funds that didn't lose too much during the financial crisis, and also did extremely well during the subsequent bull market.

Maximum drawdown from Jan. 2007 to June 2009 vs. compound annual growth rate from July 2009 to May 2015

We can exclude FSMEX since it had a worse drawdown than XLV during the financial crisis and less growth during the subsequent bull market.

An ideal fund would be in the lower right hand corner of this plot. Unfortunately, there's nothing there. FSPHX and JAGLX are far to the right with high CAGR, but they're also high on MDD. FPHAX is in a very good position, with about 25% CAGR and the lowest MDD of the remaining funds (also the lowest among all 23 funds).

In fact why not drop all of the funds to the left of FPHAX? Compared to FPHAX, they all had a worse drawdown during the financial crisis and less growth in the ensuing bull market.

That leaves us with the Fidelity Select Pharmaceuticals Portfolio (FPHAX), the Janus Global Life Sciences Fund Class T (JAGLX), and the Fidelity Select Health Care Portfolio (FSPHX).

Ranking the Final Three

The next figure shows growth of $10k in the three remaining funds since Jan. 3, 2007.

Growth of 10k in FPHAX, FSPHX, and JAGLX from Jan. 3, 2007, to May 29, 2015.

FPHAX had a less severe drawdown in 2007-2008 than the other two funds, and maintained a reasonable advantage until JAGLX caught up in the past nine months or so. The final balances were $40.3k in FPHAX, $38.9k in JAGLX, and $37.1k in FSPHX.

Finally let's look at a how the three funds compare in various performance metrics.

Table 2. Performance metrics for FPHAX, FSPHX, and JAGLX from Jan. 3, 2007, to May 31, 2015.

Ticker CAGR Mean SD Sharpe Sortino MDD Alpha Beta
FPHAX 17.9% 0.073% 1.189% 0.061 0.085 30.4% 0.025 0.920
FSPHX 16.8% 0.070% 1.234% 0.056 0.073 44.4% 0.018 0.998
JAGLX 17.9% 0.073% 1.212% 0.060 0.076 40.9% 0.023 0.978

It's hard to pick anything other than FPHAX here, as it led the three funds in every category (not including beta as a performance metric).

Expense ratios are 0.79% for FPHAX, 0.74% for FSPHX, and 0.93% for JAGLX. All three funds have a minimum $2,500 initial investment.

One point of uncertainty for FPHAX is the fact that the current manager started in April of 2013. I have to say this takes away somewhat from one of the more impressive aspects of FPHAX's historical performance, the fact that it had the smallest MDD of any of the 23 funds examined.

The current managers of FSPHX and JAGLX have been in charge since Oct. 2008 and May 2007, respectively.

I Choose FPHAX

Despite the 2013 fund manager switch, I view the Fidelity Select Pharmaceuticals Portfolio as the leading healthcare mutual fund. It has a solid track record of generating alpha and producing better Sharpe ratios than XLV. It has achieved an impressive 17.9% CAGR since the beginning of 2007, and it managed to do only lose 30.4% during the financial crisis, whereas SPY lost 55.2% and XLV lost 39.2%.

Honorable Mention

FSPHX and JAGLX are certainly on this list since they were in the final three.

The Fidelity Select Biotechnology Portfolio (FBIOX) had the highest CAGR at 21.0%, the highest alpha at 0.0317, and a very good MDD of 31.5%. Its relatively high volatility was such that its Sharpe ratio was fifth out of the 23 funds. It was filtered out because it generated positive alpha in only five of the nine years. But I think you could make the case for FBIOX being the best of the 23 funds.

The Fidelity Advisor Biotechnology Fund Institutional Class (FBTIX) is very similar to FBIOX and had similar metrics, although not quite as good.

The other two funds with higher CAGR than the "final three" were the Rydex Basic Biotechnology Fund Class Investor (RYOIX) at 20.4% and the T. Rowe Price Health Sciences Fund (PRHSX) at 19.8%.

Limitations

Subjective process

I'm sure if 50 different people analyzed the same 23 funds, they would come to various conclusions. I used a rather subjective approach to going from 23 to 3 and then choosing a winner.

However, looking at the various metrics, I do think that there would be a tendency for folks to go with either FBIOX since it had the highest growth and highest overall alpha, or FPHAX since it had the highest Sharpe and Sortino ratios, smallest MDD, and consistent year-to-year positive alpha and high Sharpe ratio.

Survivorship bias

It's a little suspicious that 22 of the 23 funds considered in this article had positive alpha and 20 had better growth compared to XLV. There's probably some survivorship bias at play, meaning that the healthcare funds included in my pool are those that have performed well and therefore survived from 2007 to today. Some amount of their survival is probably due to random chance rather than fund manager skill, which means their seemingly excellent performance is probably a bit artificial.

Past performance vs. future results

An implicit assumption of this article is that the historical performance of a mutual fund reflects the ability of the fund manager(s) to outperform the broader healthcare sector. In other words, we're hoping for some correlation between past and future performance of these funds. That's not guaranteed. But I'm not sure there is any better way to assess an actively managed fund than to look at its past performance.

Missing Funds?

Please comment below if there are any healthcare mutual funds that you are interested in but that I did not include in my analysis. I will be happy to run a quick comparison vs. the 23 included and get back to you.

Disclosure: The author is long VGHCX. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The author used Yahoo! Finance to obtain historical stock prices and used R to analyze the data and generate figures. Any opinion, findings, and conclusions or recommendations expressed in this material are those of the author and do not necessarily reflect the views of the National Science Foundation.