Your health care fund might be sick, but it's far too soon to pull the plug.

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Investors fled the cratering tech sector for health care stocks in 2000, fueling a burst of solid gains for biotech, pharmaceutical, HMO stocks and health care sector funds. The average health fund rang up a 55.4% return in 2000, easily dusting all other stock fund categories and the

S&P 500

, which lost 9.1%. In a now familiar pattern, though, a record wave of cash gushed into health care funds just in time for them to hit the wall this year.

Since Jan. 1, health care funds are down almost 9% on average and none are in the black. Some might be tempted by an instinct to dump these falling funds, but a look at the sector and how it can raise a portfolio's returns while lowering risk shows why long-term investors may want to hang in there.

One of the things that's hurting health care this year is simply that the whole sector did so well last year and valuations just got ahead of themselves, says Amy Arnott, a health care stock analyst with Chicago fund- and stock-tracker

Morningstar

. "I think it's still a promising area for long-term investors, but on the fund side we saw the pattern we often see where people piled in after a run-up, which is just the wrong time."

Pile in

is right. Last year investors stuffed more than $14 billion into health care funds, more than half of which don't have a three-year track record yet. The previous record for calendar-year inflows to health funds was $5.1 billion in 1998.

Health Monitor
Y2K marked a phenomenal year for health care funds, in returns and new cash

Sources: Morningstar and Financial Research.

And the timing of all those inflows

is

looking less than prescient to the short-term trader in all of us. Together with health funds' steep gains came high valuations, but the market has reined in those valuations in recent months. So far this year, health care funds are the worst performing stock-fund category, with even the leaders in negative territory since Jan. 1.

The stocks weighing most heavily on these funds are the pricey shares of cutting-edge biotech companies, many of their highest fliers in recent years. The five hardest-hit heath funds this year own the likes of

Genetech

(DNA)

,

Millennium Pharmaceuticals

(MLNM)

,

Immunex

(IMNX)

and

Human Genome Sciences

(HGSI)

. These four stocks are down an average of 24% this year, after averaging gains of more than 50% last year.

Many of these stocks experienced huge multiple expansions last year, and even traditionally cheaper health care stocks are pricey after last year when the

American Stock Exchange Pharmaceutical Index

jumped 27.6% and the usually sleepy HMO sector, measured by the

Morgan Stanley/American Stock Exchange HMO Index

, gained more than 115%. Given these gains, the pros say it's natural for the sector to cool down.

"Because health care did so well last year, it's bound to take a breather," says Laurel Gormley, a health care analyst with

John Hancock Funds

who helps run the firm's broker-sold

(JHGRX)

John Hancock Health Sciences fund.

Another strike against the sector in 2001 is the prospect of accelerating growth. When the economy is slowing, momentum or short-term investors tend to take shelter in more stable growth sectors like health care, a dynamic that helped health care stocks and funds last year.

But the

Federal Reserve's

interest rate cuts and the new administration's planned tax cut should eventually boost economic growth. So, the shift of momentum or short-term investors back to the tech sector is giving health care stocks an unhealthy dose of selling pressure. But health fund managers say it's important not to interpret this selling pressure as a sign that the long-term growth prospects of health care are weakening.

"Group rotation argues against health care stocks this year, but it's not that anything is really wrong," says Jordan Schreiber, manager of the broker-sold

(MAHCX)

Merrill Lynch Healthcare fund, the top health fund so far this year.

A manager from growth-specialist

Janus

says that while this year's outlook for health care stocks is uncertain, the sector should be a solid player in a long-term portfolio.

"This year is impossible to call. In December my goal was a 15% to 20% gain just based on my companies' earnings growth. Now I'm down 10%. None of my companies have had bad results, but here I am because of cyclical rotation of money out of health care stocks," says Tom Malley, manager of the

(JAGLX) - Get Report

Janus Global Life Sciences fund, which is closed to new investors. "In the short term, the market is all about psychology and in the long term, it's all about fundamentals. I think if you buy these stocks when they're getting whacked, you can position yourself for some great returns in the long term."

Cynics often say that sector-fund managers are perennially bullish on their sector because it's their job to be. But it's tough to argue with the idea that momentum selling can create a compelling opportunity for buy and hold investors.

Moreover, historical performance suggests that, when used in moderation, health care funds can both raise a diversified portfolio's returns

and

reduce its risk.

Most asset allocation models suggest you limit your sector-fund exposure to 10% of your stock portfolio. Using Morningstar data, we found that adding a 10% health care fund allocation to a portfolio that tracks the S&P 500 consistently raised returns and lowered risk over the past 10 years. If you're unfamiliar with the risk measure beta, it essentially measures volatility relative to the overall market. A beta below 1.0 indicates a portfolio is less volatile than the market; a beta above 1.0 indicates greater volatility than the market.

A Healthy Portfolio
A modest stake in a health care fund would've boosted returns and lowered your risk over the past 10 years

In looking at this data, a key point to keep in mind is that all health care funds aren't alike. A fund focusing on risky biotech stocks, for instance, will probably ramp up your broad portfolio's volatility rather than reduce it. As with all sector funds, most investors are probably best advised to look for a fund that spreads its money around a sector.

The

no-load

(VGHCX) - Get Report

Vanguard Health Care fund, which has consistently outperformed its peers while taking on less risk, is probably the cream of the crop, but its hefty $25,000 investment minimum rules it out for most investors. It's a good idea to look for health care funds that perform like it, though, which means looking for the most diversified funds that are best positioned to weather the sector's current storm.

The bottom line: While 2001 could be a lousy odyssey for health funds, they still make sense for a lot of long-term investors. If you're looking to make a quick buck on the next hot sector, though, you're probably looking in the wrong place.

Fund Junkie runs every Monday and Wednesday, as well as occasional dispatches. Ian McDonald writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to

imcdonald@thestreet.com, but he cannot give specific financial advice.