NEW YORK ( TheStreet) -- Since President Barack Obama began campaigning for health-care reform last year, health mutual funds have lagged behind.During the past year, the funds returned 25%, trailing the S&P 500 Index by 25 percentage points. Investors have worried that new rules from Washington would crimp profits of pharmaceutical companies and hospitals. Though substantial reforms now seem less likely, markets remain nervous, and many drug stocks dipped when Obama recently announced his new version of health legislation. All the concerns have left health stocks depressed, say some fund managers. The iShares Dow Jones U.S. HealthCare Index ETF ( IYH) has a price-to-earnings ratio of 12, compared to a multiple of 15 for the S&P 500. "Many health-care stocks have been trading at a 20% discount to the S&P 500," says Eric Schoenstein, manager of the Jensen Fund ( JENSX). "That is a big change from the past when health stocks usually traded at a premium because of their defensive qualities." To bet on a revival in the sector, consider holding a health fund. Top choices have outdone the market for years. But be aware that the funds follow a variety of strategies. Investors seeking a sizable stake in biotechnology and drug companies should consider Eaton Vance Worldwide Health Sciences ( ETHSX), which has returned 5% annually during the past five years, outdoing 72% of competitors. Manager Sam Isaly has 31% of assets in biotechnology and most of the rest in pharmaceutical companies. Fearing that legislation would depress health stocks, Isaly has sometimes shifted to foreign companies that shouldn't be hurt by edicts from Washington. When President Bill Clinton's proposals appeared in the 1990s, Isaly put 55% of his assets abroad. Last year, he moved 30% overseas. Isaly recently reduced his foreign stake to 20%. "It seems unlikely that major legislation will pass," he says. A favorite foreign holding is Shire ( SHPGY), a U.K.-based biotechnology company that produces drugs for attention-deficit hyperactivity disorder, or ADHD. The company's sales rose 28% last year. Islay also owns Merck ( MRK). The company could suffer from patent expirations, but the shares sell for a price-to-earnings ratio of 6, below the historic multiple. He thinks Merck has improved its research program and is developing promising drugs.
To own a mix of large and small stocks, consider Janus Global Life Sciences ( JAGLX), which has returned 4.7% annually during the past five years, beating 61% of competitors. Manager Andrew Acker holds growth stars as well as weaker companies that sell at sizable discounts. For years, Acker owned few pharmaceutical blue chips because they commanded premium prices and faced patent expirations that threatened to hurt sales. But now that drug stock prices have been depressed by uncertainty in Washington, he has bought Pfizer ( PFE). "It is generating a lot of free cash, and it is growing in emerging markets," Acker says. A growth star that he likes is Gilead Sciences ( GILD), a leading producer of HIV therapies. Earnings have climbed throughout the recession, increasing 40% last year. Aggressive investors may prefer Manning & Napier Life Sciences ( EXLSX), which returned 6.7% annually during the past five years, outdoing 86% of its peers. The fund seeks companies that can grow consistently for years and gain market share. While most health funds focus on big pharmaceutical companies, Manning is avoiding them entirely. "Some of the biggest companies have been losing market share to the generic industry," says Jeffrey McCormack, an analyst for the fund. McCormack prefers smaller companies with breakthrough products. A favorite holding is ZOLL Medical ( ZOLL), which makes defibrillators used by doctors and emergency-medical technicians to revive patients. New CPR equipment should help to boost ZOLL's sales, McCormack says. Another holding is OraSure Technologies ( OSUR), a maker of HIV tests. The company is developing over-the-counter tests for sale to retail customers in drugstores. That could increase sales dramatically. To hold a broad mix of pharmaceuticals and health service businesses, try BlackRock Healthcare ( MDHCX). Manager Robert Hodgson seeks companies with above-average growth prospects and below-average multiples. Hodgson favors pharmacy benefit managers, which oversee drug spending for HMOs and other groups. Whether or not health legislation passes, he figures that demand will grow for benefit managers that can help to control costs and encourage participants to use generics. His holdings include Express Scripts ( ESRX) and Medco Health Solutions ( MHS). Both companies should grow at double-digit rates, Hodgson says.