3 Top Funds For The Economy's Hottest Sector

Tim Begany's picture

Monday, July 27, 2015 - 7:30am

by Tim Begany

Health care stocks have delivered the strongest recent gains of any sector. As a group, they have risen  roughly 24% annually over the past five years, topping the rate of return from the next-best sector -- consumer cyclicals -- by more than three percentage points.

Look for this outperformance to continue. Among the sector's strongest catalysts: the Affordable Care Act (aka Obamacare), which looks like it's here to stay following a recent Supreme Court decision to uphold the premium subsidies available under the Act.

Despite harsh criticism and numerous repeal attempts, the five-year-old law has proven to be a boon to many health care firms by getting millions of previously uninsured people into the market for health care products and services. The graying of the U.S. population is a powerful growth catalyst, too, progressively increasing health care utilization as age-related maladies surge.

Clearly, broad exposure to health care stocks makes good sense. The question is: how best to get that exposure?

For investors who favor actively managed, no-load mutual funds, I've identified three top choices. They all have high performance ranks and reasonable expense ratios. But they're noticeably different in terms of risk. Here are all the pertinent details.

Vanguard Health Care (NYSE: VGHCX)
Total assets: $52.7 billion
Yield: 1.1%
10-yr. annual rate of return: 13.7%
10-yr. performance rank in category: 42
Expense ratio: 0.34%
5-yr. standard deviation: 10.0
Number of holdings: 89

The most conservative of the three choices, VGHCX has long been known for a buy-and-hold, value-oriented strategy with a clear preference for safer large-cap stocks. Nearly 86% of fund assets are in large caps, and the average market value per holding is almost $44 billion. Two key valuation metrics, the price-to-book and price-to-sales ratios, are substantially below category norms.

Of the 10 largest holdings, seven have been in the portfolio for more than a decade. The average holding period for these stocks is more than 14 years.

The top-10 list is dominated by stalwart pharmaceutical giants such as Merck & Co., Inc. (NYSE: MRK), Bristol-Myers Squibb Co. (NYSE: BMY) and Eli Lilly & Co. (NYSE: LLY). Allergan Plc (NYSE: AGN), previously known as Actavis, was added to the fund in 2013 thanks to its global leadership in branded and generic medications. Allergan is currently VGHCX's second-largest holding.

Because of its safety-first approach, VGHCX is 26% less volatile than the typical health care fund. You can tell this from its standard deviation, the amount of variation in the price of a fund during a specific time period. VGHCX has a standard deviation of 10, compared with the category average of 13.6. The fund outperformed 58% of peers over the past decade, despite taking less risk.

Fidelity Select Health Care Portfolio (NYSE: FSPHX)
Total assets: $10.6 billion
Yield: None
10-yr. annual rate of return: 15.4%
10-yr. performance rank in category: 29
Expense ratio: 0.74%
5-yr. standard deviation: 13.4
Number of holdings: 100

While FSPHX has a noticeably higher performance rank than VGHCX -- 29 versus 42 -- it also represents a substantial step up in risk (and expense). At 13.4, its standard deviation is more than a third higher and indicates a level of volatility roughly equal to the category average. The expense ratio of 0.74% is 30 basis points greater.

Like VGHCX, the fund owns many of the health care sector's biggest, most reliable names. Allergan, for example, is FSPHX's largest holding. The fund is riskier because it holds substantially more small- and mid-cap stocks, which are often especially volatile. Such stocks constitute a third of fund assets, compared with only 14% for VGHCX.

Overall, smaller stocks have provided a nice performance boost. For instance, number-10 holding Puma Biotechnology, Inc. (NYSE: PBYI), a $3.2-billion biotech known mainly for cancer drugs, has soared by nearly eightfold over the past three years. During the same period, FSPHX earned nearly a fivefold gain from an investment in AMAG Pharmaceuticals, Inc. (Nasdaq: AMAG), a $2.2-billion drug maker focusing on specialty areas such as iron deficiency anemia and chronic kidney disease.

VALIC Company I Health Sciences (NYSE: VCHSX)
Total assets: $982 million
Yield: None
10-yr. annual rate of return: 18.3%
10-yr. performance rank in category: 10
Expense ratio: 1.1%
5-yr. standard deviation: 14.6
Number of holdings: 100

This fund is the most aggressive of the group, with a standard deviation that's more than 7% above the category average. Yet a performance rank in the top 10% indicates that shareholders are being well-compensated for the higher risk.

Management is particularly adept in spotting growth across asset classes. Among its best performers in the large-cap space are the infectious disease specialist Gilead Sciences, Inc. (Nasdaq: GILD) and Celgene Corp. (Nasdaq: CELG), which develops treatments for cancer and immune system diseases. Shares of both firms gained more than 600% in the past five years.

Especially profitable investments in smaller company holdings include ACADIA Pharmaceuticals Inc. (Nasdaq: ACAD), which focuses on the treatment nervous-system disorders. Jazz Pharmaceuticals (Nasdaq: JAZZ) specializes in medications for cancer, narcolepsy and pain management, while DexCom, Inc. (Nasdaq: DXCM) makes blood sugar monitoring systems. These stocks jumped by 4,400%, 2,040% and nearly 700%, respectively, over the past five years.

Risks To Consider: After such a long hot streak, the health care sector could be due for a period of more tepid performance.

Action To Take --> While every stock portfolio should include some health care exposure, there isn't one health care fund that's right for every investor. The three top-notch choices described here should appeal to a wide range of investors depending on their financial goals, risk tolerance and limits on fund ownership costs.

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Tim Begany does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.