Mutual Funds Are Recuperating From Reforms

NEW YORK (TheStreet) -- Since President Barack Obama began campaigning for health-care reform last year, health mutual funds have lagged behind.

During the past year, the funds returned 25%, trailing the S&P 500 Index by 25 percentage points. Investors have worried that new rules from Washington would crimp profits of pharmaceutical companies and hospitals. Though substantial reforms now seem less likely, markets remain nervous, and many drug stocks dipped when Obama recently announced his new version of health legislation.

All the concerns have left health stocks depressed, say some fund managers. The iShares Dow Jones U.S. HealthCare Index ETF(IYH) has a price-to-earnings ratio of 12, compared to a multiple of 15 for the S&P 500. "Many health-care stocks have been trading at a 20% discount to the S&P 500," says Eric Schoenstein, manager of the Jensen Fund(JENSX). "That is a big change from the past when health stocks usually traded at a premium because of their defensive qualities."

To bet on a revival in the sector, consider holding a health fund. Top choices have outdone the market for years. But be aware that the funds follow a variety of strategies.

Investors seeking a sizable stake in biotechnology and drug companies should consider Eaton Vance Worldwide Health Sciences(ETHSX), which has returned 5% annually during the past five years, outdoing 72% of competitors. Manager Sam Isaly has 31% of assets in biotechnology and most of the rest in pharmaceutical companies.

Fearing that legislation would depress health stocks, Isaly has sometimes shifted to foreign companies that shouldn't be hurt by edicts from Washington. When President Bill Clinton's proposals appeared in the 1990s, Isaly put 55% of his assets abroad. Last year, he moved 30% overseas. Isaly recently reduced his foreign stake to 20%. "It seems unlikely that major legislation will pass," he says.

A favorite foreign holding is Shire(SHPGY), a U.K.-based biotechnology company that produces drugs for attention-deficit hyperactivity disorder, or ADHD. The company's sales rose 28% last year.

Islay also owns Merck(MRK). The company could suffer from patent expirations, but the shares sell for a price-to-earnings ratio of 6, below the historic multiple. He thinks Merck has improved its research program and is developing promising drugs.