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One of the 100 largest ETFs in terms of assets, the Health Care Select Sector SPDR Fund (ARCA:XLV), is State Street's (NYSE:STT) answer to a diversified healthcare portfolio. Over 14 years old, the ETF has $5.9 billion in total net assets with average daily volume of 6 million shares. Liquidity is not a problem. Consisting of 53 holdings averaging $84 billion in market cap, these are generally some of America's finest healthcare companies. The largest holding is Johnson & Johnson (NYSE:JNJ) with a weighting of 12.48%, followed closely by Pfizer (NYSE:PFE) at 12.16%. Its top 10 holdings represent 57% of the portfolio. Of that 57%, pharmaceutical companies represent a little more than three-quarters of the $3.4 billion in assets. A bet on the XLV is a bet on Big Pharma.
Put aside the pharmaceutical bent for a moment and consider some of the things that make XLV a great investment. When investing in ETFs, there are several things to keep in mind, and none more important than low fees. XLV's annual expense ratio is 0.18%, lower than all healthcare ETFs with the exception of the Vanguard Health Care ETF (ARCA:VHT), which is four basis points (BPS) lower. Just as with mutual funds, the headwind created by higher fees can be the difference between good long-term returns and mediocre ones.
However, fees aren't the only thing that matters. Flat-out performance is also critical, and in this regard the XLF is just so-so. Over the past 10 years, its annualized total return is 6.9%, 170 and 100 BPS less than the healthcare category and the SPDR S&P 500 ETF (ARCA:SPY), respectively. Considering SPY's annual expense ratio is 8 BPS less than XLV should give you pause before jumping in. The biggest problem with XLV is that in the years it underperforms the SPY, it does so by a significant amount. Anyone looking for low volatility might not want to go down this road.
According to ETF Database, five ETFs are available with the word "pharma" in the fund name. Since the XLV is pharmaceutically focused, it makes sense to determine if any of the five can do what it does plus more. The first important detail is that none of the five options have a 10-year track record. However, three have a five-year track record: iShares Dow Jones U.S. Pharmaceuticals Fund (ARCA:IHE), SPDR S&P Pharmaceuticals ETF (ARCA:XPH) and PowerShares Dynamic Pharmaceuticals Fund (ARCA:PJP). IHE is 100% invested in pharmaceutical companies; XPH is at 98%; and PJP is at 77%. All three have a higher pharmaceutical component than XLV at 48% of its portfolio.
None of the trio can hold a candle to XLV when it comes to management fees, where the closest is SPDR at 0.35% annually. However, when it comes to performance, despite having the highest annual expense ratio at 0.60%, PJP has the best five-year record with an annualized total return of 16.9%, 250 BPS higher than the XPH. The XLV doesn't even make double digits.
Interestingly, the PowerShares fund has the lowest pharmaceutical component of the three alternatives, providing investors with some industry diversification despite a pharma-centric approach. Replicating the performance of the Dynamic Pharmaceuticals Intellidex Index, the 30 stocks are selected using a combination of growth and value criteria. With just 30 holdings, investors should keep in mind that a smaller portfolio cuts both ways; future performance might not match past performance due to the additional company risk associated with fewer stocks.
ETFs are generally market cap-weighted, equally weighted or fundamentally weighted. Of the three, I prefer equally weighted funds because it provides better representation from top to bottom than the more commonly used market-cap weighting, which puts a premium on the top 10 holdings. Anyone who's owned a market cap-weighted ETF with Apple (Nasdaq:AAPL) as the top holding has witnessed firsthand how this affects performance. However, owning an equally weighted ETF can also be a win/lose proposition. You lose when a stock like Apple goes on a big run; but as we've seen recently, it cuts the other way as well.
The Guggenheim S&P 500 Equal Weight Healthcare ETF (ARCA:RYH) is meant to replicate the performance of the S&P 500 Equal Weight Health Care Index, which when you boil it down is really just the same 53 stocks that make up the XLV, only in much different weightings. The top 10 holdings in RYH account for just 21% of its $99 million in total assets compared to 57% for the XLV.
The No.1 holding in the equal-weight fund is Boston Scientific (NYSE:BSX) at 2.34%, while the smallest holding is Merck & Co. (NYSE:MRK) at 1.64%. In the XLV, Merck is the third-largest holding with a weighting of 7.56%. The two funds are like night and day. In terms of performance, there's no comparison. RYH has a total return of 76.2% since its inception in November 2006; the XLV's return in the same six-year period is just 42.7%. Guggenheim's fund wins by hitting singles and doubles while the XLV is swinging for the fences.
SEE: 3 Types of Indexing For ETF Success
Smaller Is Better
Boston Scientific started out as a smaller, more entrepreneurial company, as did most other healthcare companies. Some grow to be mid caps, some to be large caps and an exclusive few become giant caps like Johnson & Johnson (NYSE:JNJ) or Pfizer. All it takes is for one small cap to become a giant cap, and your investment returns spike exponentially. Not to mention small caps provide some of the more interesting corporate histories. Sure, they also come with more risk, but the potential rewards are greater too. If you want to capture healthcare, owning small caps is an important piece of the puzzle.
The PowerShares S&P SmallCap Health Care Fund (Nasdaq:PSCH) is a group of 67 healthcare stocks that are part of the S&P SmallCap 600 Index. The ETF is market cap-weighted with the top 10 holdings accounting for 36% of its $110 million in total net assets. As you scroll through a list of its holdings, unless you spend a lot of time studying the markets, many of the names won't ring a bell. That's OK. ETFs are meant for just such an occasion. Diversification, especially when you're dealing with smaller companies, is vital to your success.
The PSCH has been around since April 2010. Since that time, it has seriously underperformed its large-cap brethren mentioned previously. That's a good thing, because when the XLV begins to cool, the small-cap ETF will ride to the rescue. Best of all, its annual expense ratio is a very reasonable 0.29%. You would think when dealing in smaller, less liquid stocks, costs would be higher, but that's not the case. You don't want to bet a huge amount, but 25% of your healthcare investment wouldn't be a bad call.
The Bottom Line
If it were my $10,000 on the line, I'd invest $7,500 in the Guggenheim S&P 500 Equal Weight Health Care ETF and $2,500 in the PowerShares S&P SmallCap Health Care portfolio. By doing so, you cover all the bases.
At the time of writing, Will Ashworth did not own any shares in any company mentioned in this article.