These ETFs Lack Health Care's Promise

In 2006, the health care sector as measured by the iShares Dow Jones U.S. Health Care Index Fund(IYH Quote) lagged the S&P 500 by a wide margin. But there's reason to investigate the sector as we step into 2007.

Sometimes a sector that lags badly one year can provide leadership the next, so that's one cause for hope. Another possible catalyst for the sector in 2007 could be a slowdown in the economy. If the economy does slow down, the relative inelasticity of demand for health care products is a plus.

So in the interest of looking for a better mousetrap, iShares recently listed three subsector ETFs that I found worth exploring. However, the new vehicles came up short in the final estimation.

The fund most similar to the IYH is the iShares Dow Jones U.S. Pharmaceuticals Index Fund(IHE Quote). IYH has 48% in pharma stocks, so the two ETFs have a 0.83 correlation, and seven stocks appear in both funds' top 10s, including large weightings in Pfizer(PFE Quote), Johnson & Johnson(JNJ Quote) and Merck(MRK Quote).

However, despite both funds having a tilt to high-yielding drug companies, neither fund offers much yield, with IYH at 0.93% and IHE at 0.92%.

IHE has lagged IYH since inception because, I believe, IYH has a larger average market cap ($10.69 billion to $1.08 billion), and large-cap has outperformed small-cap in the last six months.

Things get a little zestier with the iShares Dow Jones U.S. Health Care Providers Index Fund(IHF Quote). The fund consists of insurance companies and medical testing companies, and it is substantially more volatile than IYH, with a standard deviation of 14.6 compared with 9.37.

Health care providers make up 18% of IYH, and because the health sector makes up 12% of the S&P 500, an equal weight in providers is implied to be 2.16%. So putting 10% of a portfolio in IHF is a big bet on a subsector that is more volatile than not only health care but the broader market as well.

The third iShares fund, and perhaps most interesting to me, is the iShares Dow Jones U.S. Medical Device Index Fund (IHI Quote). According to PortfolioScience.com, the standard deviation of this fund is only 12.7. This surprises me, because if you look at its top 10 holdings, you will see hot potatoes such as Boston Scientific(BSX Quote) and Zimmer Holdings(ZMH Quote). Devices make up 13% of IYH and, using the math above, only 1.56% of the S&P 500.

Picking stocks from this subsector can be difficult because many of these stocks are capable of one-day 20% drops in reaction to bad news. There are potential zero-sum outcomes to the competition between some of the companies (stent-makers, as an example), and that might mean the fund won't deliver on the growth that some of its components, held as individual stocks, might enjoy.

After looking at these, I'm not sure the plusses outweigh the minuses. Quite a few large-cap drug companies have very similar returns to IYH and IHE but with more than a 2% dividend yield: Johnson & Johnson at 2.3%, Pfizer at 4.5% and Merck at 3.5%. (As an aside, Merck has outperformed dramatically over the last few months.) Although health care is not usually known for huge dividends, I would rather not settle for the paltry yields available from IYH and IHE.