Health Care Funds Reeling From Drug Stock Overdose

But funds holding HMO stocks are doing fine.
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Ouch! Mutual fund investors lured into health care funds by the sector's robust gains in 1998 are now feeling some pain.

The funds have been falling this year, and their most nauseating returns have come since April 12, when pharmaceutical stocks started slumping. That drop coincides with a broader shift in the market away from growth and toward value.

Look at the ever-popular

(VGHCX) - Get Report

Vanguard Health Care fund, which returned 40.8% last year, far outpacing the

S&P 500's

28.6% return. The fund garnered so much attention that it had to close to new investors in March, after being flooded with $564 million of new investments in January. But the fund lost 0.5% in April and has only returned 3.6% year to date, little more than one-third of the S&P 500's 9.5% return during the same period, according to

Morningstar

.

Vanguard Health Care hasn't fallen as much as most of its peers. The average health and biotechnology fund tracked by

Lipper

lost 3.5% in April and is down 4.4% year to date.

For investors who only just got into the sector, recent returns have been a hard pill to swallow. "Investors tend to be a step late on things like this. It's definitely just one more nail in that sector-rotation and market-timing coffin," says Stephanie Kendall, a mutual fund analyst with

CDA Wiesenberger

. (If your portfolio is overloaded with health care funds and stocks, see Monday's

Dear Dagen column.)

What's happening here? One factor is the funds' holdings. The large helpings of pharmaceutical stocks that made many health care funds so attractive in recent years are now bringing them down. The

Amex Pharmaceutical Index

is down 13.3% since its high on April 12, according to

Baseline

.

"Pharmaceuticals have been the major driver behind most of the health care funds," says Hemant Shah, an independent health care analyst with

HKS & Co.

in Warren, N.J. "The sector has taken quite a beating."

But not

all

health care has wavered. In fact,

(FSHCX) - Get Report

Fidelity Select Medical Delivery, for years the butt of health care managers' jokes because of its lagging performance, outpaced them all in April, returning 9.3%. It's still down 12.0% year to date, however.

Select Medical Delivery, unlike many health care funds, concentrates in the stocks of hospitals and health maintenance organizations. Many health care managers had tagged such stocks DOA -- for Don't Own Any. But in April, those stocks have shown considerable resilience.

"Unfortunately, most mutual funds tend to be followers rather than leaders," says Shah. "They'll only buy stocks after they move up. So most of the health care mutual funds are not benefiting from managed care."

The shift toward HMOs illustrates that sector rotation can take place within a sector. Because health care is a broad sector that can be sliced many different ways, investors must take extra care to know what they own when buying a health care fund.

"When you have these big shifts, you're going to have very different results in different health care funds," says Kirsten Hudson, an analyst at

Value Line

.

Not everyone agrees that pharmaceuticals should be left for dead.

"We see the pharmaceuticals in the United States as a satisfactory value," says Sam Isaly, manager of the

(ETHSX) - Get Report

Eaton Vance Worldwide Health Sciences fund. "No. 1, they've already corrected, and No. 2, they are no longer selling at a premium to the market despite premium growth. That's an unusual situation."

Isaly still likes, for instance, drug companies such as

Roche

overseas and

Eli Lilly

(LLY) - Get Report

in the U.S.

Al Blomquist, a financial adviser in Franklin Lakes, N.J., still likes pharmaceutical-type funds such as

(FHLSX)

Invesco Health Sciences. But even he's unsure of what the sector might experience over the short term.

"If your time frame is my birthday, which is July 22, I haven't a clue," the 64-year-old Blomquist says of the drugmakers. "But if it's five years from now," he says he has a bullish outlook.

At Value Line, Hudson also points out that the market doesn't always do what it seems to be doing. She says the current "shift" from growth to value could just be another temporary aberration, just like the "correction" during the later half of 1998, when magazine covers were emblazoned with doom-and-gloom predictions.

"I tend to believe the stock market functions as one big hallucination, for the most part," Hudson says. "If you can get enough people to believe it, it's the truth. So it remains to be seen whether this is a necessary correction or if this is just

another blip like there was back in October or November."

If it is just a blip, that will make a lot of people feel better in the long run. Which, after all, is what health care is supposed to do. But for all those investors who clamored into the sector in the first quarter, a short-term remedy might be hard to come by.