Hot Health Care ETFs Face Head Winds

September 24, 2015

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by Scott Kubie, chief strategist of Omaha, Nebraska-based CLS Investments.

The health care sector has provided stellar investment opportunities in recent years.

Over the last five years, the iShares U.S. Healthcare ETF (IYH | A-94) has outperformed the broader Dow Jones U.S. Index by more than 8 percent. Health care has increased more than 22 percent per year while the broader U.S. market has increased at 16 percent per year.

Removing the annualized returns, IYH is up more than 177 percent in five years, while the Dow Jones U.S. Index has basically doubled. Both returns are very impressive. The question for health care investors is, will the outperformance continue?

More Upside Potential
The analysis below leads to the conclusion that health care stocks have potential for further upside, but most of the outperformance in the sector has already occurred.

Investors should watch price trends as well as merger-and-acquisition trends in the industry. If either slows down, investors should reduce their emphasis on health care in their portfolios.

While this analysis used the Dow Jones U.S. health care indexes, which are behind many of the subsector ETFs used in the industry, it applies to other broad health care ETFs like the Health Care Select Sector SPDR (XLV | A-93) and the Vanguard Healthcare (VHT | A-94). It also applies to the iShares Nasdaq Biotech (IBB | A-46) and other biotechnology ETFs.

Business Fundamentals
Health care’s performance has benefited from fundamental changes in the health care industry. New drug approvals are up 50 percent in the last four years compared with the previous four.

Some of these approvals have been for very-high-cost treatments that serve a narrow patient universe. The approval of applications in this area benefits many startups and increases the potential number of diseases that can be treated profitably.

The additional treatment opportunities are reflected in the business performance of biotechnology. The chart below shows biotech firms have superior historical earnings growth, wider margins and better return on equity (ROE).

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