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Healthy Choices

Steve Abramowitz

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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