Health Care ETFs Outpacing Market

September 15, 2014

Obamacare is adding fuel to a rally two-plus years in the making.

The Affordable Care Act, also known as Obamacare, is boosting health care spending, offering increasing support to a sector of the economy that continues to outperform the broader market. ETFs that invest in health care are delivering outsized returns relative to the S&P 500 Index in a pattern that has been in place for more than two years now.

Year-to-date, health care is the best-performing sector in the S&P 500 Index, delivering twice the returns of the broad index itself. The sector is up 16 percent since the beginning of the year, while the S&P 500 is up about 8 percent.

Funds like the Health Care Select SPDR (XLV | A-91), which has more than $11 billion in assets, are racing higher and breaking through record levels, much like the competing iShares U.S. Healthcare ETF (IYH | A-95), which has $2.6 billion in assets, and the Vanguard Healthcare ETF (VHT | A-93), with $3.3 billion. These ETFs offer market-cap-weighted, broad exposure to the segment.

Even more impressive has been the run-up of the First Trust HealthCare AlphaDex ETF (FXH |A-64), a $2.3 billion ETF that picks its stocks from the Russell 1000. The alpha-seeking methodology scores securities on factors such as growth and value, divides them into groups based on their rankings, and gives the top-ranked group a higher weight in the mix, according to First Trust.

In the end, the stocks in the portfolio are equally weighted within each group for a performance that’s been slightly outshining its market-cap peers. The chart below shows the total returns of FXH, and two of the biggest broad health care ETFs relative to the SPDR S&P 500 (SPY | A-99) so far this year.

Health_ETFs_YTD_Perf

Chart courtesy of StockCharts.com

Solid Case For Health Care Stocks

This upward trajectory is showing no signs of slowing down, and Obamacare has a lot to do with that. The law, passed in March 2010, but which has been slowly implemented, set out to increase access to health care by lower-income Americans, and requires everyone to be insured.

While implementation of the law has been rocky, and is not expected to be fully completed until 2020, it has already impacted companies in the sector. For example, the Commerce Department’s latest figures showed a jump of 3 percent in total revenue for health-care-related businesses in the second quarter—a sign that consumers are spending more money in hospitals and doctors’ offices, Bloomberg reported this week.

 

This spending is only expected to pick up pace.

Consider that in 2013, health care spending grew by more than 3.5 percent, and funds like XLV, IYH, VHT and FXH outperformed the S&P 500 by upward of 10 percentage points each. Now, the Centers for Medicare and Medicaid Services is projecting that spending to grow 5.6 percent in 2014, according to Bloomberg.

To that point, a recent PwC report showed that an expanding Medicaid program—as part of Obamacare—is boosting for-profit hospital’s bottom lines in a way that’s exceeded expectations, BusinessWeek reported.

Portfolio Construction Crucial

These ETFs are on the front line of the boom in health stocks. While they are only a small sampling of the 20 or so funds in the broad health sector, they are the biggest and hold the bulk of ETF assets tied to this segment.

What stands out among them is the fact that FXH’s alpha-seeking approach is delivering higher returns, something that is also directly linked to the exposure the fund offers in terms of subsectors.

Nearly 40 percent of FXH is tied to health care providers and services, some of the very names that are benefiting directly from the increase in consumer spending on health care. Pharmaceuticals represent about 18 percent of the mix.

By contrast, XLV, the behemoth in the space, allocates heavily to pharmaceutical names, which represent about 45 percent of the overall portfolio. Health care providers and services come in at 15 percent.

That’s a different makeup between the two broad U.S. health care sector ETFs, and something that directly impacts—positively or negatively—the overall returns. In 2013, FXH delivered roughly 6 percentage points in outperformance relative to XLV—47 percent versus 41.4 percent in total returns in the 12-month period.

Costs Matter

The caveat here is cost. Costs matter in total returns, and FXH is among the most expensive ETFs in the segment. The fund charges 70 bps in expense ratio, and it often lags its benchmark—an added “cost” to investors’ overall results. FXH trailed its index by a median 102 basis points over the past rolling 12 months, according to ETF.com Analytics.

XLV, meanwhile, costs 0.16 percent, or $16 per $10,000 invested, and it does a good job at replicating its index.

How VHT And IYH Stack Up

The most comprehensive of the bunch in terms of exposure is Vanguard’s VHT, which tracks the MSCI U.S. Investable Market Health Care 25/50 Index and includes health care stocks pulled from the top 98 percent of the total U.S. stock market capitalization. The fund offers possibly the broadest exposure to the U.S. health care segment, according to ETF.com Analytics.

The 308-security portfolio is, like XLV, heavily allocated to pharmaceuticals—more than 55 percent of the overall mix.

VHT is one of the cheapest ETFs in this segment, at 14 basis points a year, or $14 per $10,000 invested. It is incredibly efficient, tracking its index closely, which makes that cost even more negligible.

iShares’ IYH falls somewhere in the middle of this group with an expense ratio that’s neither the lowest, nor the highest—45 basis points a year. Like XLV and VHT, it too is heavy on pharma names, but offers a solid representative 101-holding portfolio of health care stocks that tracks a Dow Jones index.

 

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