In Healthcare, Passively-Managed Funds May Not Be The Top Investments

The Health Care Select Sector SPDR (XLV), the exchange traded fund (ETF) that tracks the Health Care Select Sector Index, gained $0.03 or 0.07% on Monday after its worst trading day of the year the session prior. On Friday the ETF shed $0.76 or 1.79% two days after setting a 52-week high. While the street has been calling for a pullback in healthcare equities, the response isn’t necessarily indicative of a trend reversal or sentiment among the broader class of healthcare names, including pharmaceuticals, biotechnology, medical devices, or healthcare services. In fact, some healthcare names appear attractive after Friday’s pullback.

We note that the fund’s returns have been driven by merger and acquisition (M&A) and strong corporate profits, rather than purely exuberance. Trading seems to suggest that investors are comfortable paying for a forward earnings multiple of about 13.6 and roughly 11x cash flow. Year-to-date the fund has returned 16.6%, excluding dividends, with the bulk of the return accounted for in the last 5 months. Part of the pullback can also be attributed to macro factors – uncertainties regarding the nation’s economy, macro factors outside of the U.S., and uncertainty heading into November’s presidential election. Notwithstanding, Healthcare equities have outperformed all other sectors in the last 6 and 12 months, as its components are largely ‘defensive’ and driven less-so by macroeconomic conditions and more-so by demographic and regulatory trends.


Select Sector SPDRs: 12 Months Performance

But the real story isn’t to do with prevalent healthcare stocks – particularly since this Healthcare ETF is largely weighted towards mega-cap pharmaceuticals and device names like Johnson & Johnson (NYSE:JNJ), Pfizer (NYSE:PFE) and Merck (NYSE:MRK). The ETF’s top 10 holdings have a 61.6% cumulative weighting, which implies poor representation of smaller components. For instance, Johnson & Johnson, Pfizer and Merck represent roughly 1/3 of the fund’s allocation. Thus, if these three names return 30%, the remaining 51 portfolio holdings could shed 15% for a 0% total return (excluding dividends). In other words, the Health Care Select Sector SPDR is not the best measure of sentiment in the broader healthcare sector, particularly in relation to small or mid-capitalization names across (mainly) biotechnology and devices. Our focus has been on these subsectors as biotech (XBI), medical device companies (IHI), and even pharmaceuticals (XPH) have largely outperformed the market. In fact, biotech has largely outperformed almost every index tracking domestic equities, with a year-to-date return of more than 34%.

But as we observe, for instance, the composition of the biotech index, we find the weighting is again skewed in favor of the top-performing components, with the fund’s top 10 holdings comprising roughly 32% of the portfolio (albeit, the ETF tracking the biotech index appears much closer to an equal-weighted index than the one tracking healthcare). The biotech ETF’s top 10 holdings are depicted in the schedule (below).

XBI Top Holdings

There are two important points to be made, pertaining to both the Healthcare and Biotech ETFs. First, as the ETFs track the Healthcare and Biotech indices, respectively, they’re considered ‘passively managed’ which means that re-balancing or ‘turnover’ happens only when there’s a change in the underlying index. This means that as top-performing healthcare index components like Pfizer or Merck continue to advance, all else being equal, they’ll constitute an even larger allocation in the fund. The issue therefore is that as few names make up a larger part of the basket of healthcare stocks, investors lose exposure to the broader healthcare sector, not to mention diversification (which, for our purposes we’ll correlate with ‘risk’). Second, as fewer constituents make up a larger proportion of the portfolio, it becomes almost irrational to expect continued strong performance as return becomes heavily correlated with the performance of equities that have already driven the bulk of returns for the fund. One of the typical approaches to alleviating this ‘exposure’ is to rebalance the portfolio, however, this is impossible for passively managed funds like the Healthcare or Biotech ETFs. Further, as individual constituents grow to a larger allocation in these passively managed funds, it becomes critical to understand what drives their value (since these individual constituents will drive the lion’s share of total return).

But there is another issue affecting healthcare equities. As we mentioned earlier, the healthcare sector is seen as ‘defensive’. Again, regulatory and demographic trends are the major drivers of value. Diversification, therefore, becomes even more important as companies of all sizes are often reliant on the success behind fewer products or product revenue streams. This is particularly true of small and mid-capitalization biotech firms that develop and later commercialize novel drugs. Larger pharmaceutical companies are similarly vulnerable to patent falloffs on products that drive earnings. A vivid example of this is Bristol-Myers Squibb’s (NYSE: BMS) pursuit of a Hepatitis-C drug candidate, which resulted in the $2.4 billion acquisition of Inhibitex. After the drug candidate showed safety concerns, the pharmaceutical giant scrapped it and wrote off the project in its entirety (NPV = $0).

These factors should deter investors from assuming biotech or healthcare ETFs are representative of the entire sector, or subsector, offer true diversification or, arguably, offer an attractive opportunity on a balance of risks/benefits. As exuberance, in part, plays a role in driving returns in biotech, at PropThink we hand-pick names as the constituents for risk-adjusted Healthcare exposure. For instance, while select names may be the biggest drivers of return in biotech YTD, this may not necessarily be true by YE, or 6-months down the road. In fact, we’ve observed on several occasion just the opposite: we’ve picked names like Questcor Pharmaceuticals (QCOR), going against popular sentiment. We find that as we research individual equities and understand what drives their value, we can create portfolios with higher alphas than the next-best alternative investment. In understanding what drives the value of select names, in healthcare services, devices, pharmaceuticals and biotech, we’re also able to understand both implicit and explicit risks that are otherwise masked, for instance, in a passively-managed ETF.

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