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  • Home>Research & Insights>Investment Insights>This ETF Delivers a Bundle of S&P 500 Healthcare Stocks at a Reasonable Price

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    This ETF Delivers a Bundle of S&P 500 Healthcare Stocks at a Reasonable Price

    Health Care Select Sector SPDR boasts a portfolio full of wide-moat names and a competitive price tag.

    Ben Johnson, 03/31/2017

    Investors seeking exposure to high-quality American healthcare companies might consider Health Care Select Sector SPDR XLV. Given the sector's relative lack of sensitivity to the economic cycle, investors seeking a defensive tilt for a broad portfolio may view this exchange-traded fund as a suitable satellite holding. XLV's holdings comprise all of the S&P 500's healthcare exposure, so owning this ETF and SPDR S&P 500 SPY means investors are effectively doubling up on healthcare. In March 2017, the healthcare sector represented about 14% of the S&P 500.

    While XLV offers exposure to many subindustries within the healthcare sector, Big Pharma firms comprised 37% of the fund's assets as of late-March 2017. XLV's heavy Big Pharma exposure shouldn't by itself deter investors, however, as the subsector weightings are representative of the entire healthcare industry.

    This fund's historical volatility has been relatively low. Its standard deviation of monthly returns over the decade ending Feb. 28, 2017, was 14.1%, which is more than a full percentage point less than the 15.3% experienced by the S&P 500.

    Fundamental View
    Historically defensive and minimally cyclical, the U.S. healthcare sector is gaining added growth from an aging America. Demand is relatively stable because people need treatment regardless of the economy, and the approximately 77 million U.S. baby boomers' need for greater treatment translates to compelling secular growth. An aging population bodes well for the industry's future, as the majority of people's lifetime medical costs are spent in their final few years.

    Many dynamics are affecting U.S. health firms. Pharmaceutical and device firms continue to merge in an effort to create scale and focus on key strategic areas. Also driving mergers are firms' desires to cut costs, tap growth avenues, deploy previously trapped overseas cash, and reduce acquisitors' tax rates through overseas acquisitions. From an innovation standpoint, drugmakers are focusing most on specialty care. As a result, pharmaceutical and biotech firms are targeting smaller patient populations, particularly in oncology, virology, and immunology. Innovating in areas of previously unmet needs should offer higher odds of approval by U.S. regulators and better pricing power for drug firms. (And despite increasing political rhetoric from lawmakers, drug and biotech firms' pricing power should remain strong, though drug pricing concerns have and likely will continue to cause higher volatility in pharmaceutical and biotech stocks.) Even drugs aimed at smaller patient populations can become meaningful contributors to large drug firms—if not downright blockbusters—particularly if these innovations' price tags are of sufficient magnitude.

    Healthcare utilization is increasing slightly, driven mostly by a stronger economy and higher insurance coverage from U.S. healthcare reform. With mandated healthcare coverage in the U.S. and expanded government insurance, clearly more are seeking out treatment, which is a net positive for healthcare firms. Of course, the potential for the repeal and replacement of the Affordable Care Act could change this dynamic. Policy uncertainty looms large over the sector.

    An aging China also offers medium- and long-term opportunities for U.S. healthcare firms. As the country ages and becomes wealthier, Morningstar's equity analysts anticipate the Chinese market will start moving the needle for large U.S. players in a variety of subsectors, including pharmaceuticals and medical technology. Assuming a normal path as China grows richer and older, healthcare's share of Chinese gross domestic product should grow from about 5% today to 40% by 2022. (China's market for health products and services currently is roughly the same size as that of Germany and France combined.) For this growth to take place, China needs to continue spending on its healthcare infrastructure, with the central and local governments expanding spending on hospitals. Another current issue in China relates to corruption, as there have been recent bribery scandals in the pharmaceutical and the medical-device industries. Chinese authorities have begun taking steps to tighten up pharmaceutical industry practices and should do the same with device firms as well.

    Portfolio Construction
    This ETF contains the 63 healthcare companies in the S&P 500, weighted according to market cap. These include firms focused on drugs (both Big Pharma and biotech), healthcare equipment and supplies, hospitals, medical devices, and health insurers. Because the index draws its constituents from the broader S&P 500, it has an inherent quality screen. In fact, seven of the top 10 holdings sport wide Morningstar Economic Moat Ratings. About 59% of the fund's assets are invested in wide-moat stocks, and 96% of assets are invested in companies with narrow or wide moats. S&P 500 holdings have to meet the standards of the S&P's selection committee, and this includes profitability and status as a leading U.S. company. Because the criteria eliminate foreign healthcare companies, the index excludes international healthcare behemoths such as NovartisNVSGlaxoSmithKline GSK, Roche RHO, and Sanofi SNY. That said, most of the firms included here are large multinational firms with businesses spanning the globe.

    Fees
    The fund's 0.14% expense ratio makes it one of the cheaper healthcare sector ETFs available. 

    Alternatives
    Vanguard Health Care VHT provides similar exposure to the sector (but has many more holdings: 358 in total) and charges just 0.10%. Fully 100% of XLV's holdings are held in VHT, and the funds' performance correlation during the past 10 years has been an extremely high 99%. Another alternative is iShares US Healthcare IYH (0.44% expense ratio), which holds 118 stocks and sports a 99% performance correlation with XLV during the past 10 years.

    Ben Johnson is Morningstar’s Director of European ETF Research.