For 2008, health funds have ranked as the top-performing equity category of mutual funds tracked by Morningstar. That may provide some comfort to investors who own health stocks for their defensive qualities -- stocks that can hold up during downturns. But compared to their showings in previous bear markets, health funds have proved disappointing lately.

During the first 11 months of 2008, the average health fund lost 28.6%, outpacing the S&P 500 by about 9 percentage points, according to Morningstar. In contrast, health funds stayed in the black during the down year of 1990, gaining 17.0%, more than 20 percentage points better than the S&P. For the difficult three-year period that began in 2000, health funds returned 0.5% annually, 15 percentage points ahead of the S&P.

The recent weaker showing of the funds may be partly caused by the changing nature of the health sector. In the past, insurance paid a big chunk of health costs, so consumers continued using drugs and scheduling elective surgeries even during times of economic recessions. But lately consumers have been forced to foot a bigger share of their bills as copayments and insurance premiums have risen. As a result, patients have been cutting back as the economy worsens. "During this recession, we are seeing a reduction in the amount of drugs used and the number of trips to physicians' offices," says Ann Gallo, portfolio manager of Hartford Global Health ( HGHAX).

Biotech Select

Not all sectors of the health category have suffered equally this year. Some biotechnology shares have remained in the black, continuing to report solid sales of vital drugs. Boasting strong balance sheets, major pharmaceutical stocks dropped 20% or less. At the same time, shares of hospital suppliers lost more than 20%. Health insurers saw their stocks cut in half as investors fled all kinds of financial businesses.

As the recession unfolds, some drug companies will face weakening sales. But health companies overall are likely to suffer far less damage than businesses in most other sectors.

While health funds offer a sound way to participate in one of the economy's strongest sectors, investors should keep in mind that the portfolio managers follow a variety of different strategies. On the aggressive end of the spectrum is T. Rowe Price Health Sciences ( PRHSX), which has returned 3.1% annually during the five years ending in November, outperforming 88% of its peers and beating the S&P 500 by 4.5 percentage points.

Portfolio manager Kris Jenner emphasizes small, growing companies that are developing breakthrough drugs. He has 42% of the portfolio in biotechnology companies. "When a small company develops a new drug, the shares can take off," says Jenner. "But if Pfizer ( PFE) develops a new drug that produces $1 billion in sales, that won't have much impact on the stock because the company is already so big."

Jenner says that some of his favorite drug companies should continue reporting growing earnings. A big biotech holding is Gilead Sciences ( GILD), which makes drugs used to control HIV. "Patients are not going to cut back on their daily HIV medicines because they understand the risks of the disease," says Jenner.

For a fund that emphasizes blue chips, consider Schwab Health Care ( SWHFX), which has returned 5.4% annually for the past five years, outperforming 93% of peers.

The fund employs Schwab's proprietary grading system that rates each stock according to 19 factors. Stocks with growing cash flows and solid balance sheets tend to score highest. "The system steers away from companies that are under stress, and that has helped us avoid trouble lately," says portfolio manager Paul Alan Davis.

Davis gives high marks to Baxter International ( BAX). The company supplies a range of medical equipment and services used in hospitals to treat cancer and kidney disease. "Baxter has diverse business lines that are necessities for hospitals," says Davis.

For broad exposure to the entire health sector, consider Hartford Global Health. The fund has 25% of assets in biotechnology, 11% in pharmaceuticals, 24% in medical equipment and 11% in managed-care companies. Hartford seeks companies with improving market shares or promising product pipelines.

A favorite holding is McKesson Corp. ( MCK), which distributes drugs to pharmacies and hospitals. Big customers include Wal-Mart ( WMT) and the U.S. Department of Veterans Affairs. McKesson is a major seller of generic drugs, a growing segment of pharmaceutical markets. "McKesson should have stable earnings growth," says Gallo, Hartford Global Health's portfolio manager.

At a time of erratic markets, steady growers such as McKesson should become especially valuable.
Stan Luxenberg is a freelance writer who specializes in mutual funds and investing. He was formerly executive editor of Individual Investor magazine.

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