5 Healthy Health-Care Mutual Funds

As the long presidential election season finally comes to an end, America's focus will quickly shift to the winner's stance on a myriad of issues, from the economy to the war in Iraq. No doubt health care will be a key topic, regardless of whether a Republican or Democrat takes a seat in the Oval Office.

We've been keeping a close eye on health care. Any initiatives a new administration comes up with could have a profound impact on the bottom lines of the companies that compete in this space, meaning, of course, that those ideas could also impact the mutual funds that invest in those companies. Election aside, health care also tends to weather economic downturns better than most sectors, and at least one expert we respect thinks it's trading cheap at the moment.

"Despite well-known political risk, there is reason to believe that this sector has favorable demographics irrespective of economic trends," Tobias Levkovich, chief U.S. strategist for Citigroup, said in a recent report. "It provides attractive valuation and the safety/security aspect being sought by investors."

This week the SmartMoney.com fund screen is giving health-care funds a checkup. There aren't too many offerings to examine, just 97 funds and share classes are listed in our Lipper database. We knocked out 80 of those because they charged a sales load. We also trimmed our potential list of finalists by searching for funds with top performance records during the trailing three- and five-year time periods. We were left with five funds; they're listed on the table below.

Recently there have been two themes parroted about the health-care industry. The first is the so-called baby boomer effect. Millions of boomers are nearing or are already in retirement. The thinking goes that as the demographic ages it will spike health-care spending by purchasing everything from complicated surgeries to routine prescription drugs. And, as we said before, health-care companies tend to perform better than their counterparts in other industries during economic slowdowns because even penny-pinching consumers won't skimp on visiting the doctor.

But that investing theme hasn't been playing out according to script in 2008. There have been reports, including one in The Wall Street Journal, that detail how consumers are actually cutting back on their medical expenses. It makes sense. If you're nearing retirement or have put your working days behind you, it must be harrowing to see your savings drop 25%, 30% or even 40% in the course of 10 months. Suddenly, keeping household costs to a minimum is a top priority. And performance has been somewhat middling. According to Lipper, health-care funds have lost an average 23.4% year to date vs. 34.1% for the S&P 500.

What's more, the health-care industry comes with some of the biggest potholes in the investing game. We don't need to delve deeply into some of the class-action lawsuits that have dogged most big pharmaceutical firms. It's already quite apparent what an unfavorable legal verdict can do to a share price. (Just picture a chart that looks like a cliff.) Then there are patent expirations to contend with. Blockbuster drugs can see their annual sales figures (often $1 billion or more) cut in half seemingly overnight once a generic equivalent hits the market. And don't forget the political angle. No doubt this industry will be impacted by the legislative initiatives of whichever candidate wins.

But for many advisors the positives outweigh the potential negatives — enough at least for health care to account for a small equity holding in a diversified portfolio.

We have just five funds on our list this week. If you are looking for broad health-care exposure, you should probably exclude the Fidelity offerings below, too. These sector funds are good performers but are narrowly focused. (Fidelity Select Pharmaceuticals (FPHAX) is the most diverse of the trio.)

One fund we wish had made our cut was Vanguard Health Care (VGHCX). We're happy to report this fund, arguably the best health-care offering out there, is once again accepting money from new investors after being closed for three years. Vanguard Health Care is in the top 10% of its peer group over the last five years and manager Ed Owens, who has helmed this offering since 1984, is considered one of the best there is at analyzing health-care stocks. You can read an interview with Owens here. But the fund missed our cut because it requires a $25,000 minimum investment. This may be one of the few times we would recommend ponying up that amount, if you can afford it, as long as it doesn't somehow overweight this industry in your portfolio. (Remember, even plain-vanilla index funds have a healthy slice of health-care stocks.)

A worthy substitute, if not an outright better fund, is T. Rowe Price Health Sciences (PRHSX). Manager Kris Jenner, a former physician, isn't afraid to put money in small health-care and biotech stocks that carry both big risks and big rewards. To offset the risk, he also weights the portfolio with a large helping of large-cap stocks. As of the fund's last disclosure filing, holdings included Gilead Sciences (GILD), Baxter International (BAX), Genentech (DNA) and Cephalon (CEPH). The fund has averaged an annual return of 10.7% over the last decade, more than seven percentage points better than the S&P 500 and good enough for a spot in the top quintile of its Morningstar peer group. That sounds like a healthy prognosis to us.

The health-care funds on our list had track records during the trailing three- and five-year time periods that put them in the top 40% of their category. They were open to new investors, required a minimum investment under $5,000 and charged an annual expense ratio less than 1.5%. As usual, we didn't include load funds.