Three ETFs to Play Pharma

NEW YORK (TheStreet) -- Several pharmaceutical companies will report earnings this week, and investors that think their reports may trigger a bullish run for the sector can seek coverage through funds such as Health Care Select Sector SPDR Fund(XLV) or iShares Dow Jones U.S. Pharmarceuticals(IHE).

Major drug companies reporting earnings this week include Abbot t Laboratories(ABT) , which reported this morning), Bristol Myers Squibb(BMY) and Eli Lilly (LLY). ABT, BMY, and LLY account respectively for 5.4%, 3.8%, and 3.1% of XLV's net assets.

Healthcare ETFs with exposure to pharmaceuticals represent a way for investors to gain exposure to the sector over the long term while hedging against the risk in holding a single company in the sector.

For instance, the share value of a single company can fluctuate heavily when there are reports that a new drug being developed is either a success or a failure. Since an ETF is diversified, the impact of a single company's one day performance, however extreme, will usually not push a fund very far in either direction. This makes healthcare ETFs useful for capturing long-term trends.

The same rule applies for the short-term during earnings season, when a company may disappoint with earnings or report a negative outlook for the upcoming quarter unexpectedly.

In this case, investors can use a fund such as XLV to try and capture bullishness on the sector that can be brought about by a positive report from a single company. At the same time, they protect themselves from the risk of exposure to a company's flop after a negative report.

Granted, a negative report from a single company can still cause bearishness for the whole sector. In the case of the pharmaceuticals, though, low valuations make a sector-wide sell off unlikely. Pharmaceutical companies, broadly speaking, are trading with very low P/Es when compared to the rest of the S&P500.

This also means that the potential gains from an overall positive earnings season could feasibly outperform the market. This is especially true if companies can convince investors that declines in valuations driven by concern that patents on successful drugs will expire soon are overdone. Convincing shareholders of this fact would be a huge positive for companies.