Traditionally, health care is considered a “safe haven” stock sector that tends to outperform in flat or bear markets but is prone to foot dragging during more bullish times. But over the last few years, its strong performance has straddled both sides of the fence.

The oldest and largest ETF in the sector, Health Care Sector SPDR (XLV), showed defensive value during 2008’s sharp downturn, when it fell 23%, compared with 37% for the S&P 500 index. In 2011, a tepid year for the market, it beat the index’s 2% return by over 10 percentage points. More uncharacteristically, the ETF also launched a strong offense during the bull markets in 2013 and 2014, when it outperformed the broader index by a wide margin.

Investors have responded by pouring money into the sector. The three largest ETFs—the SPDR offering, the iShares Nasdaq Biotechnology fund (IBB) and the Vanguard Health Care fund (VHT)—saw net inflows of $3.6 billion in 2014, up from $2.2 billion the year before.

A number of developments helped push fund flows and prices higher last year. The Affordable Care Act promised to provide a tailwind for hospital companies and health insurers, which stand to benefit from increased usage by paying customers and increased enrollments. New drug introductions pushed biotechnology higher, while generous yields on big pharmaceutical stocks attracted investors in a stubbornly low rate environment.

On a global level, emerging markets spending on health care continues to grow at a much faster clip than other areas of the economy, while an aging population is boosting demand for services. And industry consolidation is bringing greater efficiency and lower costs to companies both here and abroad.

Despite favorable longer-term trends, however, a number of developments argue in favor of buying on dips. The future of the Affordable Care Act became more clouded when Republicans took control of the U.S. House and Senate after the November elections. Government steps to discourage so-called “tax inversions” with foreign companies could have an impact on mergers and acquisitions. And after a long bull run, some analysts worry that current valuations have become a bit stretched.

In his 2015 U.S. equity markets outlook, Morgan Stanley U.S. equity strategist Adam Parker downgraded the health-care sector from overweight to market weight positioning. “After recommending health care for the last four years, we are now reducing our outlook based on more balanced risk-reward,” he noted. “While we still prefer health care to consumer staples among the classic defensive sectors, health-care price-to-forward-earnings multiples have now expanded to 10-year highs and look more in line with group multiples from the 1980s and 1990s.”

Even some health-care mutual funds managers think it may be time for a breather. In his third quarter 2014 report to shareholders, T. Rowe Price Health Sciences Fund manager Taymour Tamaddon noted that after five years as a standout performer, the sector “is likely to cool off and trade more in line with the broad equity market. Part of our reasoning is that health-care utilization rates are likely to remain depressed due to a proliferation of insurance plans that include higher out-of-pocket costs for patients.”

But the report ends on a more optimistic note by adding that the sector “represents one of the attractive growth areas in the global economy.”

For those who agree, the ETF universe offers more than two dozen health-care sector options. Some of them focus on the broader universe of health-care stocks, while others zero in on specific areas such as biotechnology or pharmaceuticals.

Broad-based
With giant pharmaceutical stocks such as Merck and Pfizer generating dividend yields in the 3% to 3.5% range, investors might expect diversified health-care ETFs to have similarly attractive income. But most of them have yields at least 50 basis points lower than the S&P 500 index because they have substantial positions in biotechnology companies, which often pay little or no dividends, as well as higher expense ratios than ETFs that track the broad market.

What’s available: Since they are all market-cap weighted, the largest members of this group—the Health Care Select SPDR, Vanguard Health Care and iShares U.S. Healthcare (IYH)—have virtually identical top 10 holdings rosters that take up about half of the portfolio and are heavily dominated by Big Pharma names such as Johnson & Johnson, Merck and Pfizer. Launched in 1998, XLV has $12.7 billion in assets, followed by VHT at $4.2 billion and IYH at $1.9 billion. Because XLV has such high trading volume, its average trading spread is just 0.01%, making it “the obvious choice for institutions and investors most concerned about liquidity,” according to ETF.com. VHT and IYH trade heavily as well and have spreads averaging a modest 0.03%. VHT has the lowest expense ratio at 0.14%, followed by XLV at 0.16% and IYH at 0.45%. The trio shares similar short- and longer-term performance.

Alternatives to the big three include First Trust Health Care AlphaDex (FXH), which uses a quantitative index based on growth and value factors. It lacks the usual Big Pharma names in the top 10 holdings and gives more space to medical equipment suppliers. Guggenheim S&P Equal Weight Health Care (RYH), an equal-weight version of XLV, also reduces exposure to big pharmaceutical companies but still has about a 40% weighting there, compared with 30% for FXH. Both have more of a mid-cap tilt than the larger health-care ETFs.

Biotechnology
Government officials rarely call out individual market sectors, so when the Fed chairman singled out valuations of smaller biotechnology stocks as “substantially stretched” in July 2014, people took notice. Nonetheless, a spate of scientific breakthroughs and acquisitions by larger companies translated into outsized returns for the group over the last couple of years, though setbacks in products under development also led to some sharp corrections. Don’t look for dividends here, since biotechnology companies often aren’t profitable, or they tend to be stingy dividend payers when they are.

Like the stocks they follow, biotech ETFs can be volatile, but they also have the advantage of cushioning the high individual security risk that marks this space.

What’s available: ETF.com classifies four funds as U.S. biotechnology, though it cautions, “none of them provides comprehensive, unbiased access to the space. Instead, each captures a piece of it—and of related industries like pharmaceuticals and medical technology.” As a result, their returns can differ dramatically from one another.

The iShares Nasdaq Biotechnology
fund (IBB), the largest of the group with over $6.6 billion in assets, tracks a market-cap-weighted index of about 120 biotechnology companies listed on the Nasdaq. Its weighted average market capitalization of $46.9 billion reflects its large-cap leanings, and it has nearly 60% of assets in top 10 names such as Amgen, Gilead Sciences and Celgene. Both First Trust NYSE Arca Biotechnology (FBT) and SPDR S&P Biotech (XBI) use an equal-weighting scheme, which gives them greater exposure to small-cap stocks. XBI has the lowest weighted average market cap at $9.6 billion, as well as the purest biotech exposure of the group.

Finally, the PowerShares Dynamic Biotech and Genome Portfolio (PBE) uses an approach that combines fundamental and quantitative factors. The result is a group of 30 stocks in biotechnology as well as peripheral segments such as pharmaceuticals and medical equipment. At $444 million, it is the smallest of the four, but it still trades at modest spreads that average 11 basis points.

Another biotech ETF, the Market Vectors Biotech fund (BBH), tracks a market index of the 25 largest biotechnology companies globally. But because U.S. companies dominate the industry, less than 10% of its assets are actually invested outside the U.S.
Pharmaceuticals

The largest industry sector in health-care indexes, pharmaceutical stocks have countered concerns about increased government regulation and patent cliffs with higher-than-average dividend yields and a growing roster of new products. According to ETF.com, just three ETFs zero in on U.S. pharma—iShares U.S. Pharmaceuticals (IHE), SPDR S&P Pharmaceuticals (XPH) and PowerShares Dynamic Pharmaceuticals (PJP). All of them tilt more heavily toward small- and mid-cap stocks than the more diversified health-sector funds, so they may appeal to investors looking for smaller, higher growth companies in this space. Expense ratios range from 35 basis points for XPH to 63 basis points for PJP.

Because of its market-cap weighting, the IHE fund, the smallest of the three with $858 million in assets, has the largest exposure to the industry giants. Equal-weighted XPH divides its $1.1 billion in assets among roughly 30 U.S. pharmaceutical companies of all sizes, although it skews more heavily toward small- and mid-cap names than the other two offerings. PJP uses a combined fundamental and quantitative approach to assemble a portfolio of roughly 30 stocks, and that semi-active management accounts for its higher expense ratio.

For those looking for global exposure, the Market Vectors Pharmaceutical fund (PPH) tracks an index of the world’s 25 largest pharmaceutical firms, including non-U.S. companies such as Novartis and Sanofi. About 40% of the fund tracks stocks outside the U.S., giving it a true foreign flavor.