In 2006, the health care sector as measured by the iShares Dow Jones U.S. Health Care Index Fund (IYH) lagged the S&P 500 by a wide margin. But there's reason to investigate the sector as we step into 2007.

Sometimes a sector that lags badly one year can provide leadership the next, so that's one cause for hope. Another possible catalyst for the sector in 2007 could be a slowdown in the economy. If the economy does slow down, the relative inelasticity of demand for health care products is a plus.

So in the interest of looking for a better mousetrap, iShares recently listed three subsector ETFs that I found worth exploring. However, the new vehicles came up short in the final estimation.

The fund most similar to the IYH is the iShares Dow Jones U.S. Pharmaceuticals Index Fund ( IHE). IYH has 48% in pharma stocks, so the two ETFs have a 0.83 correlation, and seven stocks appear in both funds' top 10s, including large weightings in Pfizer ( PFE), Johnson & Johnson ( JNJ) and Merck ( MRK).

However, despite both funds having a tilt to high-yielding drug companies, neither fund offers much yield, with IYH at 0.93% and IHE at 0.92%.

IHE has lagged IYH since inception because, I believe, IYH has a larger average market cap ($10.69 billion to $1.08 billion), and large-cap has outperformed small-cap in the last six months.

Things get a little zestier with the iShares Dow Jones U.S. Health Care Providers Index Fund ( IHF). The fund consists of insurance companies and medical testing companies, and it is substantially more volatile than IYH, with a standard deviation of 14.6 compared with 9.37.

Health care providers make up 18% of IYH, and because the health sector makes up 12% of the S&P 500, an equal weight in providers is implied to be 2.16%. So putting 10% of a portfolio in IHF is a big bet on a subsector that is more volatile than not only health care but the broader market as well.

The third iShares fund, and perhaps most interesting to me, is the iShares Dow Jones U.S. Medical Device Index Fund ( IHI). According to PortfolioScience.com, the standard deviation of this fund is only 12.7. This surprises me, because if you look at its top 10 holdings, you will see hot potatoes such as Boston Scientific ( BSX) and Zimmer Holdings ( ZMH). Devices make up 13% of IYH and, using the math above, only 1.56% of the S&P 500.

Picking stocks from this subsector can be difficult because many of these stocks are capable of one-day 20% drops in reaction to bad news. There are potential zero-sum outcomes to the competition between some of the companies (stent-makers, as an example), and that might mean the fund won't deliver on the growth that some of its components, held as individual stocks, might enjoy.

After looking at these, I'm not sure the plusses outweigh the minuses. Quite a few large-cap drug companies have very similar returns to IYH and IHE but with more than a 2% dividend yield: Johnson & Johnson at 2.3%, Pfizer at 4.5% and Merck at 3.5%. (As an aside, Merck has outperformed dramatically over the last few months.) Although health care is not usually known for huge dividends, I would rather not settle for the paltry yields available from IYH and IHE.

The provider ETF, IHF, tilts more to insurance providers such as UnitedHealth Group ( UNH) and Humana ( HUM) than to testing companies such as Lab Corp. of America Holdings ( LH).

Insurance companies carry risks such as accounting that are very difficult to measure, but I am favorably disposed to the testing companies, with Quest Diagnostic ( DGX) held for most clients. So again, my preference here would be for a common stock -- potential 20% hit notwithstanding.

I believe health care, because of the demographic aspect, will be a very important sector over the next 10 years. While I don't think these funds are all that hot, there will be more to come. A company called Ferghana Wellspring has had funds in registration for a while now that get incredibly narrow within the sector, such as its proposed Infectious Disease fund and its Gastrointestinal/Genitourinary/Gender Health fund.

You may or may not need those funds, but the point is there will be more innovative products coming, and studying them will be worthwhile.

At the time of publication, Nusbaum was long JNJ and DGX as client holdings, although positions may change at any time.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, Ariz., and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback; click here to send him an email.

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