Healthcare ETFs: 4 Things To Consider

by on October 24, 2013 | ETFs Mentioned:

The healthcare industry has been one of the fastest growing segments in the market, with the iShares Dow Jones U.S. Healthcare ETF (IYH, A) outperforming the SPDR S&P 500 ETF (SPY, A) over the past 1-year, 5-year, and 10-year periods. By enabling investors to purchase diversified exposure in a single security, exchange-traded funds represent a great way to efficiently and cost-effectively build healthcare exposure into a portfolio [see Select Sector SPDR ETFs Head-To-Head].

What’s the Appeal?

The rapid growth in the healthcare industry is being driven by several factors. According to the U.S. Administration on Aging, the U.S. population will have about 72.1 million persons over the age of 65 by 2030, which is more than twice the number in 2000, helping to justify the rapid expansion. New medical devices, pharmaceuticals and treatment options will also help extend the average lifespan–and lifetime healthcare spending–of these citizens.

Health Care ETFsA second major driver of the healthcare industry is universal healthcare coverage under new healthcare legislation implemented by the Obama administration. According to The Oregon Study published in the New England Journal of Medicine, Medicaid coverage leads to an increased use of healthcare services. Presumably, universal healthcare coverage would lead to similar increases in healthcare service usage that could further boost the industry [see Baby Boomers ETFdb Portfolio].

Combined, the aging U.S. population and increasing usage of healthcare services should support the ongoing growth of the healthcare industry.

Paying Attention To Washington

The healthcare industry is heavily impacted by government oversight and regulation. Obama’s sweeping healthcare regulations will have broad implications across both health insurance payors and healthcare companies providing drugs and devices. Changes to Medicare or Medicaid rules and regulations could have similar impacts on the healthcare industry, as they can dramatically impact reimbursement status and amounts for numerous industry participants.

On a smaller scale, the U.S. Food and Drug Administration (“FDA”) also has a dramatic impact on medical device makers and drug manufacturers. Individual companies stake their fortunes on the success or failure of the FDA regulatory approval process for both pharmaceutical drugs and medical devices. Moreover, the FDA can extend patent lifespans or provide other ancillary benefits for companies in the space by granting certain statuses for the drugs or devices [see 3 Sector Rotation Strategies ETF Investors Must Know].

Overall, the success and failure of the healthcare industry rests largely in the arms of Washington, from the highest levels to the lowest levels.

Considering Different Sub-Sectors

The healthcare industry outperformed the broad market in 2012, with the Vanguard Health Care ETF (VHT, A+) trading up nearly 19.02% compared to the S&P 500 SPDR ETF (SPY, A) more modest 15.99% gains. However, investors can find even better performance by looking at sub-sectors, like pharmaceuticals or biotechnology, which have outperformed the broader healthcare industry by wide margins in some cases [Download 101 ETF Lessons Every Financial Advisor Should Learn].

Here’s a look at some sectors that outperformed and underperformed in 2012:

Sub-Sector ETF Ticker Symbol 2012 Performance
Biotechnology BBH 47.36%
Pharmaceuticals PPH 12.98%
Healthcare Services XHS 22.06%
Healthcare Equipment XHE 13.43%

Despite some of this outperformance, investors should be aware that some sub-sectors may entail greater risks. A good example may be the biotechnology segment, which is by far the most research-intensive in the industry. While the sub-sector outperformed the broader healthcare market in 2012 in total returns, it historically exhibits lower and more volatile profits and higher market-related risks.

The morale of the story is that investors should carefully consider both total returns and risk factors in order to maximize their risk-adjusted returns over time [see How To Take Profits And Cut Losses When Trading ETFs].

Going Global

Many healthcare companies reduce risk by diversifying their operations internationally, since a lot of risk is concentrated in individual countries’ regulatory structures. Fortunately for investors, there are many international healthcare ETFs that can offer diversified worldwide exposure. The SPDR S&P International Healthcare Sector ETF (IRY, B+), for example, includes no U.S. exposure and counts Switzerland as its largest component with 23.4% of its portfolio [try our Free ETF Country Exposure Tool].

Investors looking for a single ETF that offers both U.S. and international exposure may instead want to consider the iShares S&P Global Healthcare Sector Index Fund (IXJ, A), which has about 60% exposure to the U.S. and 40% exposure internationally. With over 90 holdings, the fund holds about 75% pharmaceutical and biotechnology stocks and 25% healthcare equipment and services, with its largest position being Johnson & Johnson (JNJ) at around 8%.

Overall, international healthcare ETFs offer investors a great way to diversify their risk by moving outside of the U.S. government’s reach.

The Bottom Line

The healthcare industry is rapidly growing, thanks to the combination of an aging population and increasing spending. While the government plays a big role within the industry, investors can diversify their exposure by placing money in different sub-sectors or even different countries in order to round out the perfect portfolio.

Disclosure: No positions at time of writing.