Viagra. Zoloft. Slim-Fast. Lasik. The healthcare industry is cranking out new drugs and innovations at a dizzying rate, with more promised breakthroughs always on the horizon. And successful breakthroughs often translate directly into big profits. Healthcare funds provide retail investors a means of participating in the growth opportunities of the health-based industries, along with professional management and diversification. (Learn about mutual funds in our Mutual Funds Tutorial.)

What is a Healthcare Fund?
Healthcare funds invest in the stocks (and occasionally fixed-income securities) of companies that operate within the healthcare sector. This encompasses a wide range of industries such as pharmaceuticals, biotechnology, health insurance providers and manufacturers of diagnostic equipment and supplies. The vast majority of healthcare funds are invested solely in equities and can fall into the growth, blend or value categories in the Morningstar style box. The managers of these funds seek out companies that have upside potential from new drugs, discoveries, patents, products and even methods. Like real estate and natural resources, healthcare funds often tend to have low r-squared values, as much of their performance is unrelated to overall market or benchmark activity. (For more, see Morningstar Lights The Way.)

Historical Performance
Healthcare funds tend to be defensive in nature, because the need for medical care is universal and often independent of economic cycles. Since 2002, the S&P 500 Health Care Index has ranged from about 300 in 2002, to as high as 425 in 2007, and as low as 250 in early 2009. As you can see, even though healthcare funds tend to have a lower correlation to the broader market, they are still vulnerable to the market's up and downturns, like any other fund.

Advantages and Disadvantages
The defensive nature of healthcare funds makes them attractive to conservative investors. Many of the major pharmaceutical companies pay hefty dividends, and this can help to offset lagging stock prices in bear markets.

Pharmaceutical companies have reaped billions of dollars in profits from blockbuster drugs like Viagra and Lipitor. Biotechnology companies are finding new applications for lasers, improved methods of looking inside the human body through resonance imaging, and other similar breakthroughs on a daily basis.

From a defensive point of view, people will continue to get sick and injured and require medical treatment, regardless of economic conditions. This unique combination gives the healthcare sector an edge over other sectors such as technology or precious metals, which are much more vulnerable to market conditions. (To learn more, see The Ups And Downs Of Biotechnology.)

However, the healthcare industry is vulnerable to political legislation and public perception, especially when it comes to big-name drugs that prove to be hazardous. For example, Merck & Co. was forced to yank its top-selling painkiller Vioxx after research indicated that it was a possible cause of heart attacks in some users. Patent expirations can also weaken the stock price of a company that had formerly cornered the market on a specific drug or treatment that was vital for patients and users.

Who Should Invest in a Healthcare Fund?
Both growth-oriented and defensive-oriented investors will find things to like in the healthcare sector. The steady dividends paid by some of the larger healthcare companies are attractive for conservative investors seeking stable income, while growth and income investors can reasonably expect to be rewarded on both fronts over time, albeit in a cyclical manner. Tax-conscious investors should also carefully examine the portfolio turnover ratio of any healthcare fund they consider. Although turnover in healthcare funds is generally not as high as funds in the tech sector, they can still distribute substantial capital gains in years of strong growth.

There are many healthcare funds from which to choose, and some industry-focused funds such as biotechnology or medical devices are also worth considering. Healthcare funds can range in investment objectives, just like any other sector, from funds investing heavily in large corporations with considerable market share, to funds investing in individual firms specializing in medical innovation, to sector funds that mimic the movements of a healthcare sector index. (For more, see Measuring The Medicine Makers.)

Healthcare is one of the major sectors of both the U.S. and world economies, and it will continue to grow as new research and advancements are brought to market. However, patent expirations and negative publicity have also taken their toll on this sector. (To learn more, check out Investing in the Healthcare Sector.)

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