Healthcare, the third largest sector weight in the S&P 500, is continuing its resurgence this year, with many basic healthcare index funds and exchange-traded funds (ETFs) posting double-digit gains. While the sector is rebounding after last year’s malaise, the group offers other advantages that investors may not be thinking of at the moment. For example, playing defense with an ETF such as the iShares U.S. Healthcare ETF (IYH) is not a bad idea for investors concerned about a sudden spike in market volatility. The $1.85 billion IYH, which tracks the Dow Jones U.S. Health Care Index, holds nearly 120 stocks.
Four sectors, including healthcare, are widely viewed as defensive groups. However, those other three sectors – consumer staples, telecom and utilities – are not only sensitive to interest rates but are often traded at valuations that are above those on broader market benchmarks, such as the S&P 500. On the other hand, healthcare is not expensive. (See also: Guard Your Portfolio With Defensive Stocks.)
“Since 1995, S&P 500 large-cap healthcare stocks have typically traded at a 10 percent premium to the market,” said BlackRock, Inc. (BLK) in a recent note. “Today they trade at nearly a 10 percent discount, close to a six-year low. To some extent, this drop in relative valuation is justified. Profitability is down from the glory years of the late 1990s when pharmaceutical companies were churning out a record number of blockbuster drugs. Currently, the return on equity is roughly 18 percent, below the 22-year average of 20 percent. Still, profitability has been improving in recent years and is currently at the highest level since 2013.” (See also: Key Financial Ratios to Analyze the Healthcare Industry.)
The fact that valuations on healthcare stocks and ETFs are currently attractive is made all the more compelling when noting that biotechnology, a group that often trades at premiums to the broader healthcare space, figures prominently in healthcare indexes and ETFs. IYH allocates over 22 percent of its weight to biotechnology stocks, the ETF’s second largest industry weight after pharmaceuticals. Perhaps due to the inclusion of faster-growth biotechnology and medical device makers, the healthcare sector can be seen as adventurous relative to other defensive groups. (See also: A Quick Guide to Healthcare ETFs.)
One thing healthcare is not is sensitive to is rising interest rates, possibly making it a good sector bet for the current environment. “Given lower financial leverage compared to other defensive industries, healthcare is less sensitive to rising rates,” said BlackRock. “For example, since 2010, the level of the 10-year Treasury has explained roughly 20 percent of the relative value of the healthcare sector. However, during the same period, the level of long-term rates has explained nearly 70 percent of the variation in the relative value of the consumer staples sector.” (See also: Top 3 Healthcare ETFs for 2017.)