Health-Care Funds Are Ailing in 2008

Whenever the market tanks like that, some forward-thinking investors start to look at the horizon and speculate on what might do well once things start to get better. And that's what usually draws attention to health-care stocks. Because consumers can't skimp on their heath like they can on a night on the town or a new car, the sector tends to do well during tough economic times. Indeed, according to Citigroup (C) health care has outperformed the broad market in each of the last 11 post-bubble trading pullbacks.

This week the SmartMoney.com fund screen focuses on the health-care industry. There are just 101 funds and share classes that focus on buying drug companies, equipment makers or hospital chains. We narrowed our list down to 18 by knocking out load funds. After we added in our usual performance and expense criteria, we were left with three funds. They are listed on the table below.

As a group these three funds have done remarkably better than the broad market during the trailing 52 weeks — and they charged a third less fees than our cutoff of 1.5%. But if you take a closer look at the health-care category as a whole the picture isn't as rosy. According to Lipper, year-to-date through Thursday the category was averaging a loss of 8%, slightly lagging the broad market. The funds do seem to be surging the last 13 weeks. Nevertheless, it seems like the health-care trend so frequently touted isn't as strong this time around — at least not yet.

In a recent write-up on the sector, Citigroup says the discrepancy is probably due to shareholder fatigue. Investors have tired of dealing with drug recalls, class-action lawsuits, patent expirations and pipelines that contain little possibility of producing blockbuster drugs that made health-care stocks so alluring in the first place. Citi says many clients have simply stopped asking about the industry. "Investors have basically given up," the report says. "Too much money has been lost over the past few years in too many places."

But as every good stock picker knows, when investors leave a sector for dead it's probably a good time to pick up some bargains. Indeed, in that same report Citi estimates the sector will average an earnings growth rate of 7% this year — and that number could easily inch higher. Citi is now recommending overweight positions in health-care equipment, services, pharma and biotech, and it thinks the industry is where information technology was 12 to 18 months ago. In other words, savvy investors can scoop up shares on the cheap that will probably pop on the slightest bit of good news as the market rediscovers the industry.

Our experts, though, aren't so willing to take that advice. "Trying to time the market is a losers' game," says Barry Korb, president of Lighthouse Financial Planning in Potomac, Md. Korb argues that most investors get plenty of health-care exposure through a plain old index fund. The S&P 500 usually has an 11% weighting in health care. We would add that if investors do make a side bet on this sector that it be a small one, maybe a few percentage points of an overall portfolio.

In that case, there are a few options to consider. IShares, one of the most popular lines of exchange-traded funds, has ETFs that focus on biotech (IBB), device makers (IHI) and medical providers (IHF). The iShares Dow Jones U.S. Healthcare Sector fund (IYH) tracks an index of 143 companies, including Johnson & Johnson (JNJ), Pfizer (PFE), Abbott Laboratories (ABT), Merck (MRK) and Wyeth (WYE). The fund charges a cheap $48 for every $10,000 invested.

Any time an investor is dealing with a sector it probably pays to go with a seasoned manager. Arguably the best health-care fund on the market is Vanguard Health Care (VGHCX). The fund is in the top 3% of this category the last decade. However, good luck getting in. It's been closed to new money since 2005.

A worthy substitute, if not a better outright option, is T. Rowe Price Health Sciences (PRHSX). Manager Kris Jenner, a one-time medical resident, scours the entire health-care industry for good buys trading on the cheap. He isn't afraid to buy smaller firms — almost half the fund is in midcap and small-cap stocks. But he tempers that risk with large-cap names that are more stable. According to Morningstar, his top holdings are Gilead Sciences (GILD), Alexion Pharmaceuticals (ALXN), CVS (CVS) and Genentech (DNA). The fund has returned 10.7% over the last decade, good enough to put it in the top 10% of the category. It also only charges $83 for every $10,000 invested, one of the cheapest annual fees around.

The Criteria
The health-care funds on the table below were open to new money, required a minimum investment under $5,000 and charged less than a 1.5% annual expense ratio. They had performance track records that put them in the top 40% of their category over the trailing three- and five-year time periods. In addition, year-to-date these funds were doing better than the broad market. Finally, we didn't include load funds.

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