Getting Defensive With A Health Care Fund

"The first wealth is health."  Ralph Waldo Emerson

Over the entire course of 2007, I've heralded the defensive attributes of investing in the Health Care sector with specific emphasis in my "Where To Invest In 2008" series of posts.  Health Care ranked only second to Technology in third quarter 2007 year over year corporate earnings and that leadership looks to continue in the short-term, with healthy prospects in the long-term, as well... 

Today, I'll fire up my fund screening software and spotlight a health care fund for your knowledge (and potentially, your portfolio)...

First, why would you want to invest in Health Care stocks to begin with?  There are a handful of reasons: 

• Regardless of the direction of the broader stock market and economy, people still need to go to the Doctor and buy drugs.  For this reason, health care has low sensitivity to macro-economic concerns and a low correlation to broader stock market performance; therefore, the sector is considered to be a "defensive" investment with great value as a diversification tool in asset allocation.
• Short-term market conditions are volatile, to say the least, and any downward pressure on stocks makes the defensive use of health care even more pronounced -- and more attractive -- to investors.
• Long-term conditions also favor the sector:  The massive baby-boom generation, the oldest of which turns 62 in 2008, demands the best in health care; therefore, over the next 10 years, spending on health care is expected to double, outpacing the growth of wages, inflation, and the economy as a whole. 
• Advances in technology has created (and will continue to fuel) an explosion in scientific understanding.

Can any health care fund or Exchange Traded Fund (ETF) accomplish the short-term defensive and long-term performance objectives we are seeking?  Not, necessarily...  Here's what we need to find: 

• Ideally, we will simultaneously harness three critical variables:  1) An aging population, 2) The favorable science and technology environment, and 3) Limited exposure to the sector's primary risks of regulatory pressures and political scrutiny (especially considering the approaching presidential election).
• To achieve this, the fund should be well-diversified among the "sub-sectors" of health care, meaning less exposure to the large pharmaceutical companies ("big pharma") and more exposure to other sub-sectors, most notably bio-technology ("bio-tech"), than the average health care fund.
• The need for lesser exposure to big pharma and for navigation through those political and market forces makes the use of an actively managed mutual fund prudent. 
• This is because, alternatively, the vast majority of passively-managed Index funds and ETFs invest heavily in big pharma or are too concentrated in only one sub-sector, such as medical devices; therefore, I completely eliminated Index and ETF funds from my search. 
• Some (but not all) of the criteria that I prefer for mutual funds include:  Manager tenure greater than five years, below-average expenses, high performance ranks compared to category peers, favorable risk attributes (as measured by Sharpe Ratio, Beta, and Alpha), and low Turnover.

And the winner is...

T. Rowe Price Health Sciences (PRHSX).  The fund passes all of my selection criteria with flying colors!  Most notably, as of November 9, 2007, PRHSX out-performs nearly 90% of other health care funds year-to-date and has outperformed more than 90% of category peers for 1-year, 3-year, 5-year, and 10-year returns!

For added insight, here's a paragraph directly from the fund's prospectus:

We believe that generating outperformance in the health care sector will be increasingly dependent on effective stock selection, rather than an emphasis on a particular subsector of the health care industry.  As always, we seek the strongest companies in each of the four main areas of health care:  pharmaceuticals, biotechnology, services, and medical devices.  Although each subsector offers attractive growth opportunities, we favor therapeutic companies developing novel products for unmet medical needs.

Of course, it should be noted that, taken alone, sector funds carry more risk than funds diversified across several other sectors of the economy; however, the proper exposure to a sector, such as health care or real estate, that has a low performance correlation to other stocks is prudent.  Therefore, I (and most reputable advisors and planners) suggest limiting portfolio exposure to any given sector fund to a range of 5 to 15 percent allocation. 

I hope this exercise was helpful.  Please let me know if there are investment areas of interest you would like to see covered here at TFP and if this type of information is useful to you...

TFPAuthor, Kent N. Thune, is the President and founder of Atlantic Capital Investments, LLC (ACI), a 'fee-only' Registered Investment Advisory firm located in Mount Pleasant, SC.

Comments

[Kris]

The negatives about the T Rowe fund are the high expense ratio and lots of volatility (down over 20% one year). I prefer an index with lower expenses and a more stable return (lower standard deviation) given that this is already a narrow sector fund.

[The Financial Philosopher]

Kris:

I will not argue that the low expenses and typically lower volatility of index funds are valuable; however, I do not believe PRHSX's 0.87% net expense ratio is "high."

To extend on a point I made in the post, I decided to stay away from index funds and ETFs because they all tend to over-weight pharmaceuticals, which is a sub-sector of health care that I believe to carry undue risk in the short-term and does not leverage the baby-boom factor as well as bio-tech in the long-term. I did not elaborate on this but I am sure that the "price-weighted" and "cap-weighted" natures of various passive funds have skewed the fund holdings. At times, this can be unfavorable to an investor, especially in the "less efficient" areas of the market (outside of mega-cap stocks) and stocks with greater "non-market" risks such as the regulatory and political risks inherent with health care...

Also, I never pay attention to Standard Deviation because I do not invest in just one fund -- I'm building portfolios. Put simply, two "risky" assets with high volatility can make one "less risky" portfolio with "low volatility." Adding a "risky" asset to a portfolio, when done correctly, can actually reduce the overall risk of the portfolio. The key is proper diversification...

I will post on standard deviation some time in the future. It is an often mis-understood statistical value and should not be considered the equivelant to "risk," especially when more than one asset is used in a portfolio.

Thanks for adding to the discussion and for provoking thought... Please comment again!