President Bush's victory last November has given health care stocks their widely expected post-election bounce. But owning individual health care names remains perilous, a lesson learned the hard way most recently by investors in Merck ( MRK) and Chiron ( CHIR), among others. One way investors can smooth out the risk -- while paying a third of the costs of the average open-end health care mutual fund -- is to buy health care exchange traded funds, which have the characteristics of a mutual fund yet still trade very much like stocks. Three of the four health care ETFs available -- Health Care Select Sector SPDR ( XLV), iShares Dow Jones U.S. Healthcare ( IYH) and the Vanguard Health Care VIPERs ( VHT) -- focus solely on U.S. stocks. Each member of the trio returned close to 9% over the past three months, while the S&P 500 gained 6.4%. The XLV, IYH and VHT could be considered top-heavy, with each ETF holding well over 50% of its assets in the same 10 names and 25% of their assets in just two stocks, Pfizer ( PFE) and Johnson & Johnson ( JNJ). Rounding out the list are: Amgen ( AMGN), Abbott Laboratories ( ABT), Merck, Medtronic ( MDT), UnitedHealth ( UNH), Wyeth ( WYE), Eli Lilly ( LLY) and Bristol-Myers Squibb ( BMY). The iShares S&P Global Healthcare Sector ( IXJ), the fourth pharma ETF, has trailed the U.S. benchmark index by a slight 20 basis points since last October. Since this index also incorporates international manufacturers, it carries European pharma giants GlaxoSmithKline ( GSK), Novartis ( NVS) and Sanofi-Aventis ( SNY) in its top 10, displacing Medtronic, Wyeth and Bristol-Myers Squibb. The four ETFs shake out quite differently beyond their top 10 holdings, however. The XLV is a select sector SPDR (often referred to as a "Spider") comprising the 55 health care stocks in the S&P 500. As a result, the XLV is the most concentrated of the group and therefore the most susceptible to price swings if a major pharmaceutical company stumbles.
Options are available on the XLV and IYH for investors looking to further reduce volatility by buying puts or selling covered calls on the respective ETF. The XLV carries an expense ratio of 0.28%, which matches low-cost provider Vanguard's offering, the VHT. For its part, the VHT tracks the MSCI U.S. Investable Market Health Care Index and holds 296 stocks, the most of the four ETFs. The IXJ charges 0.65% and the IYH charges 0.60%. And while those ratios may seem high compared to the other two offerings in the group, they still cost less than a third of the 1.93% Morningstar average for an open-end health care mutual fund. Merrill Lynch also offers another option for health care investors, the Pharmaceutical HLDRs Trust ( PPH). The PPH consists of 21 major health care names from Abbott Labs to prosthetics maker Zimmer Holdings ( ZMH). Interested investors should take note, however, that while HOLDRs -- short for holding company depositary receipts -- have many of the same characteristics as ETFs, such as transparency and liquidity, there are important structural differences. HOLDRs don't track a specific index, as traditional ETFs do. And once the HOLDR starts trading, the baskets are not rebalanced on a quarterly or biannual basis, unlike index ETFs. That means the proportions of stocks within the HOLDRs can change drastically, at times leaving an issue heavily concentrated in just a few names. The issue of concentration is worth considering when it comes to the PPH, which has nearly 55% of its portfolio in just three stocks -- Johnson & Johnson, Pfizer and Abbott Labs. There is, however, no annual fee to own HLDRs, just transaction costs for purchases and sales. Finally, investors preferring to focus on biotechnology stocks might be attracted to the iShares Nasdaq Biotechnology ( IBB) ETF. The IBB contains 149 stocks and charges an expense ratio of 0.50%. Nevertheless, the cautionary flag arises once again over the concentration issue, as 16% of the fund is held in biotech bellwether Amgen. "Health care stocks and especially big pharma were under pressure last year due to the Vioxx recall and the Celebrex alert, but they have demonstrated earnings and sales growth recently and that has brought money and confidence back into the market," says Sena Lund, an analyst at Cathay Financial. "Right now, pharma stocks are a good long term value here, but the next few months might be a bit rocky."