Diluting Risk in Health Care

Despite all the political turmoil over health care and persistent Republican efforts to defund the Affordable Care Act, health care has been a top-performing sector in the mutual fund universe.

With an average return of 39.6 percent over the trailing one-year period, the health sector has been the third best performer, while topping the chart over the trailing three-year period with a total return just shy of 23 percent. Health care has also been one of the best performing US sectors for most of this year.

Nonetheless, many investors find the health care sector intimidating, having a tough time balancing more established players with cutting-edge biotechnology companies that have the potential promise of high profits but are extremely high risk. And while the health care sector as a whole is generally less volatile than the broader market, you can still find some shockingly high betas in a few niches of the sector.

So for many investors, it’s sensible to make a broadly diversified bet on health care, relying on professional money managers with expertise in the sector to maintain a portfolio of health care companies for them. There are also a number of passively managed index funds which could yield healthy profits for more cost-conscious investors.

On the passively managed front, Health Care SPDR (NYSE: XLV) is a terrifically diversified exchange-traded fund (ETF) that holds a basket of 55 health care companies, ranging from big pharma such as Pfizer (NYSE: PFE) and Merck (NYSE: MRK) to veterinary-focused companies such as Patterson Companies (NSDQ: PDCO) and insurers such as Cigna (NYSE: CI).

Only 18.6 percent of assets are in the fund’s top ten holdings and most positions have an average weighting of only about three percent, which means problems at any one company aren’t likely to sway performance. The fund also has extremely low turnover of just 5 percent annually whi! ch, coupled with its ETF structure, means there’s very little potential tax exposure aside from any capital gains you may owe when you sell a stake in the fund.

Given its extremely diversified portfolio with an emphasis on larger companies, the fund is rarely a top-performer in the health care category, typically ranking closer towards the middle of its peer growth. So far this year, it has returned 34 percent compared to 36.4 percent for the sector as a whole and has generated an 8.5 percent return over the past 10 years, compared to 9.4 percent for the sector.

While you do give up some return with Health Care SPDR, you gain much more peace of mind in terms of both potential tax liability as well as volatility. The health care sector is historically much less volatile than, say, the S&P 500, but Health Care SPDR is also less volatile than the health care sector itself. Its three-year beta relative to the broad S&P 500 is just 0.69, while it’s just 92 percent as volatile as the sector itself. It’s also inexpensive, with an annual expense ratio of just 0.18 percent.

By comparison, more risk-tolerant investors should consider a targeted, actively managed fund such as Fidelity Select Biotechnology (FBIOX, 800-544-8544).

Manager Rajiv Kaul invests in higher risk, higher reward bitotech companies but he doesn’t take a particularly speculative approach to the niche. While some managers try to identify potential winners among development stage companies, Kaul focuses primarily on companies that already have a product on the market or are in late-stage development with a product soon to be approved.

On average, the fund has about 150 holdings at any one time with annual turnover running at 42 percent, as Kaul lets his winners ride and tends to trim losers fairly quickly. As a result, he’s held some companies such as Amgen (NSDQ: AMGN) and Gilead Sciences (NSDQ: GILD) since the late 1990s, with a number of newer positions such as Intrexon (! NYSE: XON! ) and Prosensa Holding (NSDQ: RNA), which have been added over the past few months.

The fund is a consistent top performer in the health care category, ranking in the top one percent on a one-year and three-year basis. It also falls into the top 6 percent of health care funds on a trailing 5-year basis and the top 8 percent over the past decade.

But with that market beating return also comes substantially more risk; the fund’s three-year beta relative to the health care sector is 1.41, while it comes in at 0.91 relative to the S&P 500.

Taxes are also more of a concern with Fidelity Select Biotechnology, since it is actively managed with fairly high turnover. So far this year it has distributed 5.5 cents of short-term capital gains to shareholders, while in 2012 it distributed $5.70 cents in long-term capital gains and 77.9 cents of short-term gains. Those distributions were made regardless of whether or not you sold your shares.

Considering America’s graying demographics and the radical market expansion the health care sector is experiencing thanks to health care reform, most investors understand that they should have some exposure to the health care sector in their portfolios.

If you choose to do that through funds, one of the biggest decisions you must make is just how much risk you can tolerate and whether you should go with a conservative fund such as Health Care SPDR or something more aggressive such as Fidelity Select Biotechnology.

You’ll also need to consider you own tax situation, with the SPDR being best for taxable accounts while the Fidelity fund would be well suited for an Individual Retirement Account or other tax-deferred vehicle.