Vanguard Health Care: A Good Place To Invest For The Future

Summary

• The increasing prevalence of a few diseases has caused the life expectancy in the United States to decline for the third straight year.
• One of these diseases is diabetes, which is a chronic condition linked to rising obesity rates and it is only going to get more common over time.
• This should bode well for healthcare companies as this increases the demand for their services.
• Healthcare is a defensive sector that has consistently beaten the S&P 500 over the past fifteen years.
• VHT is a good, low-cost way to play the sector.
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Last week, the Centers for Disease Control reported that the average life expectancy in the United States has fallen for the third straight year. The primary reasons that the agency gave for this trend was an increase in deaths from suicide, the flu, diabetes, and drug abuse. In short, we have a rising death rate due to an increasing prevalence of both diseases and substance abuse. While this is undoubtedly a very strong negative for society as a whole, it also tells us that the demand for healthcare services is likely to surge over the coming years as people seek out treatment for these conditions. One way that investors can take advantage of this is by purchasing shares of the Vanguard Health Care ETF (NYSEARCA:VHT).

About The ETF

The fund is designed to track the performance of the MSCI US Investable Market Index/Health Care 25/50, an index made up of stocks of large, mid-size, and small U.S. companies within the healthcare sector. This category includes both manufacturers of healthcare products, such as medical device providers and pharmaceuticals, as well as providers of healthcare services, such as hospital operators. It thus provides us with a broad spectrum of companies that are likely to benefit from people seeking out assistance with their medical problems.

As is the case with many industries in the United States, the index is dominated by a few large firms. In fact, the index itself has been modified from a purely market capitalization-weighted one to accommodate the dominance of a handful of very large firms. This is necessary because of a provision in the US Internal Revenue Code that limits the holdings of registered investment companies, which would include most ETFs. One of these rules is that no more than 25% of the value of the fund's assets can be invested in a single issuer and the sum of the weights of all issuers with greater than a 5% weighting cannot exceed 50% of the fund's total assets. As a pure market capitalization-weighted index for the healthcare industry violates these rules, the index used by the fund has been modified to fit within the rules. Even so, though, the top ten holdings of VHT still account for 44.20% of the fund's total assets:

Source: The Vanguard Group

As my regular readers are no doubt well aware, I generally do not like to see any individual holding in a fund to have greater than a 5% weighting. This is because a weighting above this level begins to expose the fund as a whole to idiosyncratic risk. Basically, should some event occur that causes the stock price of a highly-weighted company to decline, it could very easily drag the fund as a whole down with it. Here, we see that the fund has four such heavily weighted companies, with one of them, Johnson & Johnson (JNJ), occupying a very large 9.40% of the overall fund. Fortunately, as healthcare enjoys somewhat inelastic demand, these companies are normally much more stable than most are. In addition, Johnson & Johnson is a very diversified healthcare company that is active over all the healthcare space, so this situation is not as concerning as it would otherwise be. However, it is still a risk that you need to consider.

Why Invest In Healthcare?

As mentioned in the introduction, life expectancy in the United States declined year-over-year for the third consecutive year:

Source: Zero Hedge

The reason for the decline in life expectancy is an increase in suicide deaths, unintentional injuries, and a few specific diseases:

Source: Zero Hedge

Note, in particular, the increase in deaths related to diabetes. This is a chronic condition that I have discussed on this site several times before, particularly in regards to Novo Nordisk (NVO), and it is one that is almost certain to become more common in the coming years. This is at least partly due to the rising obesity rate, which is expected to climb to 55% by 2040 from 39% today, as obesity is often a strong risk factor in the development of type-2 diabetes. This is particularly relevant to our healthcare investment thesis because diabetes is a chronic condition, so once a patient contracts it, they will continue to need products to treat it for the remainder of their lives. Thus, an increase in the diabetes rate represents a steady increase in the revenues of those companies involved in treating the disease and as the disease is chronic, these revenues will compound.

Another factor that should prove positive for healthcare going forward is the aging of the Baby Boomer generation. The 72 million currently living members of this generation are currently aged 53-72 years old, so we can see that within the next decade, the oldest members of the generation will pass their eightieth birthday and within thirty years, all of them will have passed this milestone. As a general rule, an individual's need for and consumption of medical products and services tend to increase sharply once an individual reaches this age. As the Baby Boomer generation is larger than any generation that came before it, this will necessarily cause strong demand growth amongst the companies in the industry.

Performance

Despite healthcare generally being considered to be a defensive sector, the index has performed surprisingly well over the past several years. As we can see here, VHT has averaged double-digit annual returns over any of the ordinary comparison periods:

Source: The Vanguard Group

With the exception of the three-year figure, these returns are generally better than the Vanguard S&P 500 ETF (VOO) has produced:

Source: The Vanguard Group

Unfortunately, VOO only dates back to 2010 while VHT was launched in 2004. Thus, the performance figures from the S&P 500 ETF would not include the 2008 market crash and the following recession. As these figures would pull down the overall performance of the S&P 500 ETF, the performance figures from VHT look even more impressive. Overall then, we can see that healthcare has been a very good performing sector historically and it looks as though it is well-positioned to perform even better over the coming years.

Fees

Vanguard has become well known for the very low fees that it charges for its funds. This is appealing to investors for a very good reason: fees act as a drag on returns; so the lower the expenses that you have, the more of your returns that you get to keep, so the higher your returns all else being equal. As might be expected from a Vanguard fund, VHT has a very low expense ratio of only 0.10%. This is much lower than the 0.43% charged by the iShares U.S. Healthcare ETF (IYH), but it is a full sixteen basis points higher than the Fidelity MSCI Health Care Index ETF (FHLC). As both funds track the same index, the Fidelity ETF may be the better option, although Vanguard does distribute its profits to its funds, which may help offset some of this fee, I cannot see that offsetting the full difference between the two.

Conclusion

In conclusion, healthcare looks like a very good place to be right now. As the population ages and certain chronic conditions become more common, the companies in the industry will see rising demand for the products and services that they provide. The fund itself is heavily-weighted towards a handful of large companies, but this is fairly typical among American ETFs and the defensive nature of healthcare helps to offset some of the risks. In addition, healthcare has consistently beaten the S&P 500 index over the years, so this reinforces our conviction that having some of your assets here is likely a good idea. Finally, VOO boasts one of the lowest expense ratios in the industry, allowing you to keep more of your money over time. Investors may want to consider either VOO or its competitor FHLC as a staple of your portfolio.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

I am long NVO through closed-end healthcare funds.