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TheStreet Open House

The Big Screen: Health Care Funds That Make the Grade

Health care funds might look a little sick these days, but they're good portfolio medicine when taken in moderation. So let's give them a check-up.

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The health care sector is a many-splendored thing, giving health fund managers a diverse menu of industries to choose from, including companies that make new drugs, design medical devices or run hospitals. Given the legions of aging Baby Boomers and the gush of new drugs coming to market, the sector has put together a nice little run. The health care pack took an eight-year streak of positive returns into this year, and it was a rare salve during last year's tech implosion, ringing up a 55.4% gain, on average according to Morningstar.

But now investors have turned a jaundiced eye toward the health care sector's frothy valuations, sending shares of big pharmaceutical shops like Schering-Plough (SGP) and Bristol-Myers Squibb (BMY) down more than 20%, and whacking shares of biotech firms like Millennium Pharmaceuticals (MLNM) and Genentech (DNA) even harder. The average health fund beats the S&P 500 over the past one-, five- and 10-year periods, but it's down 7.8% this year compared to a 2.3% dip for the S&P.

Healthy -- Until Lately
Source: Morningstar. Returns through June 4.

Let's look at why even conservative investors might consider adding a health care fund to their portfolio. Then we'll look at a few funds that have consistently topped their peers and the stocks that helped them do so.

In general, sector funds are riskier than more diversified stock funds because they bet the farm on one slice of the market, rather than spreading their bets among different sectors that rise and fall in distinct cycles. That said, the health care sector can hold up well in downturns as investors become smitten with its fairly dependable earnings.

In fact, history shows us that adding a 10% stake in the average health care fund would've both boosted the returns and reduced the risk of a diversified U.S. stock portfolio. Over the past 10 years the (VFINX) Vanguard 500 Index fund has averaged a 15.2% annual gain, but that goes up to 15.5% if we add a 10% position in the average health care fund, according to Morningstar. Adding a health care fund also reduces risk if we compare the portfolios' worst one-year losses and their betas -- the measure of a portfolio's volatility compared to the S&P 500.

More Return and Less Risk
Putting 10% of a diversified portfolio's money into a health fund would've boosted returns and reduced risk over the past 10 years.
Source: Morningstar. Data through May 1.

Volatility
100%: Vanguard 500 Index fund 90%: Vanguard 500 Index fund10%: Avg. Health fund
Worst Year -21.6% -19.4%
Best Year 52% 50.2%
Three-Year Beta 1.0 0.96
Source: Morningstar. Data through May 1.

Of course, picking a health fund is far from easy. Over the past few years, many funds loaded up on shares of biotech firms -- cutting-edge drug labs -- whose products and stocks are the equivalent of a home-run swing. Consider that since the start of 1998 the American Stock Exchange Biotechnology Index is up more than 300%, but between 1993 and 1996 its cumulative return is a negative 3.3%.

For most investors it's probably a good idea to stick with a health care fund that has a broader approach and more all-weather performance. To find some, we screened the 47-fund category for funds that topped their average peer over the past one- and three-year periods with their current skipper at the helm. Just three made that cut, so let's put them -- and some other worthy candidates -- under the microscope.

A Trio of Survivors
Health stocks have zigged and zagged over the past three years, but these funds have stayed ahead of their peers.
Health Fund 3-Year Return 1-Year Return
(ETHSX) Eaton Vance Worldwide Health 39.1% 25.5%
(VGHCX) Vanguard Health Care 24.9 25.8
(MAHCX) Merrill Lynch Healthcare 21.9 17.7
Avg. Health fund 21.5 14.9
S&P 500 6.2 -11.5
Source: Morningstar. Returns through June 5.

Each member of this trio has managed to ring up returns that beat their peers, while also losing less than the average health care fund in down months over the past three years. They pulled that off by spreading their bets and choosing wisely.

Sam Isaly, manager of the broker-sold (ETHSX) Eaton Vance Worldwide Health fund since 1989, made the list by charting a distinct course. Looking for companies with solid earnings growth and a reasonable stock valuation, he splits his portfolio almost evenly between stocks of pharmaceutical and biotech companies. Unlike most health care fund managers, he diversifies among small-, mid- and large-cap stocks. And his 30% stake in foreign companies more than triples that of the average health care fund.

That approach has added up to a solid track record as the fund beats at least 75% of its peers and the S&P 500 over the past one-, three-, five- and 10-year periods.

Ed Owens has ridden a diversified strategy to similarly eye-catching results with the no-load (VGHCX) Vanguard Health Care fund, where he's called the shots since the fund's 1984 inception. The $17.4 billion fund is far and away the nation's biggest sector fund, but Owens' slow-and-steady style doesn't rely on alacrity. He spreads the fund's billions broadly across the sector, making minor moves to overweight whatever sliver of the sector he thinks is poised to rise at any given time.

Owens' approach might not get your pulse racing, but his fund beats the S&P 500 and at least 66% of its competitors over the past one-, three-, five- and 10-year periods, according to Morningstar. The only downside of the fund is that, to control in-flows, Vanguard has raised its minimum investment to $25,000 for new investors.

Like the other two funds on our list, the broker-sold (MAHCX) Merrill Lynch Healthcare fund didn't get there by taking outlandish chances. Manager Jordan Schreiber, who stopped by for a 10 Questions interview recently and has held the fund's reins since 1983, gives investors broad health care exposure with a bent toward big-cap pharmaceutical stocks. The fund tops its average peer and the S&P 500 over the past one-, three-, five- and 10-year stretches, according to Morningstar.

Another health care fund that's worth a look, but didn't make our list, is the no-load (DGHCX) Dresdner RCM Global Health Care fund, run by Faraz Naqvi and Michael Dauchot since 1999. The fund has topped its average peer each calendar year since its launch at the end of 1996. Though these managers haven't been in place for three years, they've stayed ahead of the pack, despite a penchant for mercurial biotech shares. The fund's 34.2% annualized gain over the past three years tops 84% of its peers and its 6.4% tumble so far this year is less steep than its average competitor.

If you're wondering what stocks propelled the funds that made our list, look no further. We tossed the three funds' portfolios into a pot and sifted out a cumulative top-10 holdings, turning up most big-cap pharma fare like Pharmacia (PHA), American Home Products (AHP) and Pfizer (PFE).

Under the Hood
Toss the three funds on our list into a pot and these are their 10 favorite stocks.
Stock Percentage of Cumalitive Portfolios YTD Return
Pharmacia 4% -18.7%
American Home Products 3.1 -0.1
Pfizer 3.0 -6.6
HCA 3.0 -6.8
Eli Lilly 2.8 -5.3
Genzyme 2.3 27.2
Amgen 1.9 9.5
Abbott Laboratories 1.9 9.1
Altana 1.8 N/A
Tenet Healthcare 1.7 6.5
Source: Morningstar. Data through May 1.

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