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YOU’VE PROBABLY never heard of Carolyn Lynch. Shopping for groceries, she noticed a new display of panty hose packaged in colorful plastic eggs. She bought a pair, tried them on and loved them. She told her husband, Peter Lynch, the celebrated manager of Fidelity Magellan Fund and vocal advocate of “investing in what you know.” He promptly bought the stock. L’eggs became one of the most successful women’s consumer products of the 1970s.
I recently had my own L’eggs moment. Standing in a line of people waiting to fill their prescriptions at CVS, I was struck that we were all elderly. Most were probably retired and many were undoubtedly struggling with one or another major health concern. We’re not alone. The U.S. is experiencing a glut of old folks like us.
As you’re no doubt all too aware, with age comes medical problems. But ironically, awareness of our susceptibility to illness presents an opportunity—investing in companies that manufacture drugs, supply medical products and insure our access to them.
But how deep does your knowledge go? How company specific? Are you aware that Biogen has participated in the development of two newly launched Alzheimer’s drugs? Will Intuitive Surgical succeed in adapting its Da Vinci Surgical System from assisting in prostatectomies to gynecological procedures? You get my drift.
Maybe you didn’t have to study for your high school biology final, but getting up to speed here is going to take a swath of retirement time. Then you remember what Harry told you yesterday at the gym. He had done well with Vanguard Group’s health care mutual fund. Harry is given to self-promotion. Still, he had the mega-bucks to shell out for that kitchen remodel. You felt you should check it out.
You were impressed by what you found. Vanguard Health Care Fund (symbol: VGHCX) performed exceedingly well over the 10 years through March 31, averaging 12% a year. It accomplished this while fluctuating only about two-thirds as much as the average stock fund. You were familiar with Vanguard’s reputation as a low-cost fund provider and weren’t surprised by the skimpy 0.3% management fee, very reasonable for an actively managed fund.
But Harry wasn’t done. He said over the weekend he’d read about a more recent sequel to mutual funds called exchange-traded funds (ETFs). These funds hold a fixed portfolio of stocks or bonds, don’t trade and require no active portfolio management. With streamlined research departments and negligible transaction costs, they often produced better returns than their actively managed mutual-fund predecessors. No portfolio manager? No trading? You were skeptical, but you thought it deserved a look.
Sure enough, Vanguard has a health care ETF (VHT) and it has been even more profitable than the firm’s professionally managed mutual fund. The ETF returned 12.7% annually over the decade through March 31. What’s more, it also bounced around less than the market and had a minuscule 0.1% expense ratio. The cumulative effect of the lower fee probably explained much of the ETF’s ability to produce better results than the mutual fund. All the research and trading in the active fund were, practically speaking, worthless.
No doubt you get the thrust of this vignette. The counterintuitive takeaway has been confirmed in hundreds if not thousands of major studies: ETFs—and passive index mutual funds—perform as well as and often better than their active mutual fund counterparts. But a dose of common sense is needed to temper any giddiness about what you can realistically expect from a health care ETF. Interest rates for the next 10 years are unlikely to return to the microscopic level we enjoyed a couple of years back. Without that tailwind, stocks probably won’t perform quite as well as they have over the last 10 years.
Now, get ready for a curve ball. Will you at least consider an ETF from another fund family with a higher but still moderate expense ratio of 0.4%? BlackRock’s iShares series offers a global health care ETF (IXJ) that enhances diversification by holding a 30% allocation in international stocks. Including foreign companies in your portfolio gives you a foothold in Europe and Asia, which will have disproportionately large populations of seniors.
I know I’ve wandered off the trusted Vanguard path to sensible retirement investing. After all, 0.4% is four times the 0.1% expense ratio offered by Vanguard. Still, over a five-year span, the cumulative excess fee on a $10,000 lump sum is only $150. Although iShares gained 10.3% a year over the past 10 years, more than two percentage points less than the Vanguard ETF, the difference can be explained by the likely temporary underperformance of international markets. International stocks comprise almost half of the world’s market capitalization. After a frustrating decade that has led many market observers to believe foreign stocks are undervalued, why ignore stalwarts like Roche and AstraZeneca out of fear, home country bias or overdone frugality?
But if you buy a health care fund, go easy because there’s an important caveat. Pharmaceutical stocks are highly represented in health care portfolios and they’re vulnerable to government regulation that would impose a cap on drug prices. As with any sector fund, a health care fund should be limited to no more than 10% of your stock portfolio.
Steve Abramowitz is a psychologist in Sacramento, California. Earlier in his career, Steve was a university professor, including serving as research director for the psychiatry department at the University of California, Davis. He also ran his own investment advisory firm. Check out Steve’s earlier articles.
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Is it possible to be nostalgic for a fund? For a few years I held FSMEX for all the reasons Steve mentioned: medical for stability and technology for growth. In 2008 FSMEX went down only -23% compared to -36% for most equity funds. But at 0.68% expense it did not quite make the cut when I reduced my average expense down to 0.11%. Now every time I see an advertisement for a medical device I am reminded that I sold the fund. Perhaps I will try IHI next time; its expense is only 0.39% and is comparable to FSMEX in other aspects.
I have been a big fan of IHI for many years, until I let it go as part of my checkered past. Just checking in with Morningstar, it seems to have the advantage over FSMEX—a lot cheaper, slightly less volatile and slightly better performance. One caveat though is that like the drug companies the device stocks are very vulnerable to a Medicare shakeout. Sorry it took me so long to get back.
This article is a “light bulb” moment for me. I was recently in the waiting area of our local orthopedic center waiting for my wife’s physical therapy session to finish. There was a constant line of people in casts, wheelchairs, crutches, etc waiting to check in. My thought was “how do I invest in this business?” Upon checking I found that this center – and many others – are owned by the doctors themselves. So Steve’s article has highlighted a possible way to invest in this segment.
By the way Steve, do you really look as much likeTed Danson as your photo?
Ha ha! I may look like Ted Danson, but at least I’ve got some hair! I’m from the old generation that still admires Robert Redford.
An industry or individual stock cannot outperform the entire market indefinitely. Given enough time, if one did that, it would eventually become the entire economy.
Healthcare has gone from 5% of GDP in 1960 to 18.3% of GDP in 2021. Not sure how much more bloat the industry can take on..
Hi Nate
You summed up the efficient market hypothesis in a few succinct words. I worry about the 25% tech allocation in the S&P. I’m not sure as they evolve into greater size and maturity they can still power a high level of growth.
Steve, you could be right. Although, I worry that “tech” is too vague a term since almost all industries increasingly use tech in their operations.
However, you do point out another reason I invest in the broad market: I personally do not know where the next innovation is coming from.
Pretty sure I read that Vanguard HC since 1984 has averaged about 15%
I checked this out as either a
(Sorry for error in prior post.)
I checked this out as either wrong or another one of those mere anomalies. But you’re right, 15.43% right off Vanguard’s website. This is an amazing performance over general funds over this period and unlikely just to be a fluke statistical outlier. Furthermore, it had only two-thirds of the broad market’s volatility. Note though that the fund’s positive discrepancy has over the years become more in line with the averages.
Thank you Steve for this really interesting take, exactly what readers want from Humble Dollar. As a sector-biased investor this is a lot of confirmation bias on my part (also, my career is in healthcare to there’s that too). To add to your great observation, I would add that the Peter Lynch analogy was intended for individual stock picking vs a sector play, but obviously the extrapolation makes sense, in not a safer balance between an industry overweight (e.g., Vanguard Healthcare) vs. a single stock (e.g., Intuitive Surgical). When it comes to choosing which path I suppose it all comes down to risk tolerance.
Hi
Yes, risk tolerance is key, but often very hard for people to reliably assess. It’s one thing to think you’ve got a handle on it practicing on paper or if your advisor says “a 20% drubbing in 6 mo. is “possible,” quite another when you’ve got skin in the game. Like most of the successful ones, you have learned from your own personal experience, you’ve got the right “gene.”
From Jan 2005 to Mar 2023: $10000 invested in each with reinvested dividends
VG Healthcare ETF (VHT) – $61,726 CAGR 10.49% Max drawdown -35.10%
VG Consumer Staples ETF – $53,709 CAGR 9.65% Max Drawdown -29.37%
VG Total Market Index (VTI) – $48,692, CAGR 9.06%, Max Drawdown -50.54%
VG Utilities ETF (VPU) – $46,306 CAGR 8.76% Max Drawdown -38.13%
Annual Dividend Income in 2022
VHT – $843
VDC – $1235
VTI – $749
VPU – $1399
Sorry, not a VTI fan.
This is one of the most important posts I’ve received since writing for Humble Dollar almost a year ago. It strikes at the heart, quite convincingly, of the efficient market hypothesis—that over relatively long periods of time random bounces of individual stocks (and sectors) will cancel each other out and not surpass the performance of a broad market index fund.
I have more than the usual sympathy for this point of view. It has an intuitive appeal and I have spent much of my investment career trying, unsuccessfully, to dethrone it.
The post presents the beat-the-broad-market point of view in what appears—at first—a simple, convincing rebuttal to Fama and French. But I think it is wrong.
Let me say at the outset I have only gone out ten years, as per Morningstar’s performance data, and I have done the additional calculations by hand. I have also rounded everything out to the nearest hundred. All the figures reflect total return. Here goes:
Hi Steve,
Portfolio Visualizer will only go back to Jan 2005 for the funds I (I’m a “she”) randomly picked for “boring”, “non-glamorous” sectors.
ETA: I am overweight healthcare in my portfolio of individual stocks. Have always been.
My error: VTI performance was $33,700, not $35,000. But SPY $35,000 is correct. Sorry.
My HSA is 50% VHT (VG Healthcare ETF) and 50% IHI (iShares Medical Devices ETF).
Steve, I was close to the Pharmaceutical business during my 50-year career. I thought they had a legal way to steal, but I could also tell I would be no good at picking the winners. So the light came on and mutual funds were the idea. We’re talking about the early 1980s. I now have 4 Healthcare funds, my biggest is with Vanguard, only because it was the first. My T. Rowe Price has been the best performer over the past 15 years, and all have equaled, or bettered the S&P 500 index. Somewhere in my readings, I ran across an adviser saying 50% was OK in healthcare. I’ve also bought a small position in ARKG, after reading The Code Breakers: Jennifer Doudna, I’m a big believer in CRISPR, and it has the possibility of revolutionizing healthcare as we know it. I think healthcare is good for another 5 or more years, but as the government ends up paying for more and more healthcare, the profitability is going to get less and less.
Ed Bye RPh.
When Jonathan notifies me my article is live, my great fear is that someone far more knowledgeable than I am about the topic will show up. Congratulations!
A couple of things:
A little concerned about that 50%. You have the knowledge to monitor developments, but many readers may not. For most people, I really think 10% is more advisable.
Very interesting about what you said about that T.Rowe Price fund. For many years it was managed by someone I thought really new his stuff. I can’t quite remember his name (Jenner?). But in general I am not a fan of T. Rowe Price because their fees are quite high.
Fascinating how many of the comments refer to fund families other than Vanguard. How many of our readers use ex-Vanguard funds but are too “embarrassed” to admit it!
Remember, the warning of the efficient market—very unusual to be able to predict market prices over time, although the length of time you’ve succeeded with health care may represent one of those anomalies.
Thanks for the interesting article. I doubt I’ll ever commit any additional funds to sector investing but I understand the allure of health care. I sometimes wonder if/when reform to the industry might take hold and lessen the profitability of all the private companies involved. This would be something to monitor if overweighting healthcare, though such reform may never happen or be many years away.
I should have mentioned a lot depends on the social and political climate. It almost seems that the vulnerability of health care and especially pharmaceuticals depends very much on who’s in power. I thought that the success of our drug companies during the pandemic gave them great PR but I don’t think that has had staying power.
Staying on the health-care and Fidelity path, their health care fund (FSPHX) has been an outstanding performer (after fees) for those who like active management. M* currently gives it a 4-star Gold rating.
By the way, the late Mrs. Lynch was a wonderful person and a world class bridge player.
Yes, Fidelity has some good active sector funds but, although their expenses are reasonable on an industry-wide basis, let’s face it, it’s not like Vanguard. But also let’s face it, its service is not as good. Of course, if you’re a long-term buy-and-hold investor, that’s not all that important. And certainly not as important as the cumulative advantage of the lower fees.
A note on Fidelity and sector funds. Many many years ago they introduced “select” (sector) funds that even included hourly (!!) exchange privileges. But the industry was more conservative at that time and the select funds never achieved prominence. Now sector funds have proliferated and sector ETFS have been a revolution. How’s that for “market timing!”
Steve, interesting article. Vanguard is strong in general on international stocks, recommending they comprise up to 40% of a stock portfolio: Why invest internationally? | Vanguard Maybe at some point they’ll offer an international health care fund or ETF, with Vanguard’s typical rock bottom fees.
Hi Andrew
I hope it would be a fund because a fund is much more friendly to dollar cost averaging (like on a monthly basis). Over time, even the small spread on ETFs takes its toll.