Summary
- In August, I wrote an article entitled The World Of 4,818 Faces An Uncertain Future. In such an environment, I believe the Health Care sector is worthy of your consideration.
- In this article, I draw from two pieces of research to explain why this is the case.
- Initially, I planned to focus on VHT as my ETF of choice. But, the more I looked, I felt like I needed to consider XLV as well.
- In the end, I pick a winner while at the same time yielding that "beauty may be in the eye of the beholder."
(This article was co-produced with Hoya Capital Real Estate.)
Back in August, I wrote an article entitled The World Of 4,818 Faces An Uncertain Future .
By "the world of 4,818," I am referring to the confluence of circumstances that culminated with the S&P 500 reaching its all-time high of 4,818 during the trading session of January 4, 2022. Essentially, this referred to what some have described as a "Goldilocks" environment, fueled by these two factors:
- A period of significant financial stimulus, with the Fed not only lowering short-term interest rates to zero but also engaging in what is known as quantitative easing (QE).
- A strong trend towards globalization. A world of cheap labor and resources, in which strong supply chains were built, goods were produced cheaply, then transported efficiently to the ultimate consumer. Credit Suisse Investment Strategist Zoltan Pozsar has referred to this as the "low inflation world."
The article then went on to explain why this has all changed and why, as I put it, "it will be difficult to quickly return to the world of 4,818."
Health Care - An Attractive Sector In An Uncertain Future
As I pondered what to write about in this article, I thought about market sectors that have the potential to do well, even in light of the uncertain future I referenced in that August article. Two came to mind; Consumer Staples and Health Care. I hadn't written about health care in awhile, so I took a little time to dig into it.
For this section of the article, I will briefly focus on the big picture, using projections from the U.S. Bureau of Labor Statistics (hereafter BLS) as well as an insightful business outlook from McKinsey & Company.
Most outlooks that I am reading at the current time project at least some level of recession in our future. This will ultimately offer a chance for inflation to come back to a reasonable level and, in turn, allow the Fed to ease up on monetary tightening. Unfortunately, it will also lead to job losses.
With respect to that, the BLS publishes an Occupational Outlook Handbook, broken down by occupation groups. Briefly, I will summarize what they have to say about health care . In terms of the overall outlook, BLS offers this overview.
Overall employment in healthcare occupations is projected to grow 13 percent from 2021 to 2031, much faster than the average for all occupations; this increase is expected to result in about 2 million new jobs over the decade . In addition to new jobs from growth, opportunities arise from the need to replace workers who leave their occupations permanently. About 1.9 million openings each year, on average, are projected to come from growth and replacement needs. (Italics mine)
It is interesting to note that pay for many of these occupations far exceeds the median annual wage for all occupations of $45,760. For example, physicians and surgeons average in excess of $208,000, dentists average $163,220, and nurse practitioners and physician's assistants come in at over $120,000.
At the other end of the spectrum, at an average of roughly $30,000, healthcare support occupations, such as home care aides and occupational therapy assistants come in well below the median annual wage.
In either case, however, the BLS projects that demand for these occupations will grow much faster than the overall average. Clearly, the employment case in this sector is strong, even in the face of recession.
Turning now to the business outlook, here is some information from McKinsey & Company in a report entitled The future of US healthcare: What's next for the industry post-COVID-19 .
Leading off the report, McKinsey offers the following.
Healthcare industry EBITDA grew 5 percent pre-COVID-19 (between 2017 and 2019) and remained flat over 2020 and 2021. We estimate post-COVID-19 (between 2021 and 2025) growth at 6 percent (Exhibit 1). If the industry achieves this rate of growth, it could add about $31 billion in profits between 2021 and 2025.
In terms of breakdown by segments, here is Exhibit 1, referred to in the above quote.
Projected Health Care EBITDA Across Segments (McKinsey & Company)
McKinsey does sound a cautionary note, namely that persistent consumer inflation could put a dent in those projections. At the same time, as I think about the investment outlook, it seems that persistent consumer inflation will be a headwind virtually anywhere one would look.
Continuing on in the report, here are very brief synopses of a couple of trends McKinsey identifies:
Shifts in sites of care - The COVID-19 pandemic has accelerated the movement of care from high-cost acute and post-acute sites to lower-cost freestanding and non-acute sites, including increased demand for home-based services and virtual care. Due to the lower costs as a result of this trend, EBITDA margins could improve.
Exacerbation of chronic conditions - The chronic disease burden has been rising for years and will continue as the number of older people grows. During the pandemic, many patients delayed or skipped necessary care, including physician visits and medical tests. In addition, many reported an increasing number of challenges related to their mental health.
In response, companies are evolving their business models - For example, hospital systems have been expanding across the care continuum, accumulating assets in ambulatory sites, virtual and digital health, primary care, and post-acute care. Home health and hospice companies are expanding into more sophisticated care delivery like hospital-at-home. Pharmacy players are scaling their primary-care businesses with acquisitions of physician and clinic assets, including value-based physician players.
McKinsey sums it up this way:
As players build new capabilities, they are recognizing that these capabilities can become large, profitable businesses in their own right.
In summary, while the health care sector has held up fairly well during the recent market downturn and therefore may not offer the greatest potential for exciting returns, I still believe it is an attractive sector in the midst of an uncertain future.
VHT vs. XLV - Digging Into Two Worthy Contenders
When I set out to write this article, honestly my initial focus was on Vanguard Health Care ETF ( VHT ). Although it has been years, I have written about this ETF before . However, as I dug in a little deeper, I felt that I should also take a look at The Health Care Select Sector SPDR Fund ( XLV ).
As a very high-level overview of how this plays out, have a look at this compact, yet comprehensive graphic, courtesy of Hoya Capital Income Builder .
VHT vs. XLV - Key Data Points (Hoya Capital Income Builder)
Before we get into any differences, let's talk about the things the two ETFs share in common. First of all, they both have an excellent long-term track record, with VHT having an inception date of 1/30/2004 and XLV going back even further, at 12/22/1998. Secondly, they both sport huge AUM; with VHT at $16.964 billion and XLV at $39.872 billion. Finally, they both carry the same expense ratio of .10%. In each of the 3 metrics, these are amazing numbers for a sector fund.
Looking back at the graphic, let's now talk about a meaningful difference between the two. It can quickly be seen that VHT has a significantly larger number of holdings than does XLV; 410 vs. 66. (Not that it makes a huge difference, but VHT's website lists the number as 405 as of 9/30/22 and XLV's site shows 64 as of 11/1/22). What accounts for this difference?
Basically, it boils down to this. The two indexes used are based on very different starting points. Here, from VHT's summary prospectus , in the description of the index used.
The Fund employs an indexing investment approach designed to track the performance of the MSCI US Investable Market Index ((IMI))/Health Care 25/50, an index made up of stocks of large, mid-size, and small U.S. companies within the health care sector, as classified under the Global Industry Classification Standard (GICS).
In contrast, here is the similar specification for XLV, from its fact sheet .
The companies included in each Select Sector Index are selected on the basis of general industry classification from a universe of companies defined by the Standard & Poor's 500 Composite Stock Index ("S&P 500").
As can be seen, whereas XLV starts with the S&P 500, and therefore includes only large-cap stocks, VHT takes a broader approach, also including mid- and small-cap stocks.
Let's see how this plays out. Due to the layout on Vanguard's website, I had to capture VHT's industry breakdown and Top 10 holdings in two separate graphics. Here they are.
VHT: Industry Breakdown (Vanguard)
VHT: Top 10 Holdings (Vanguard)
Here is the same information for XLV, in a single graphic due to a more compact layout.
XLV: Industry Breakdown & Top 10 Holdings (State Street Global Advisors)
Let me quickly point out the similarities, as well as some differences.
First of all, the Top 10 holdings are identical in both ETFs. However, due to the lower number of holdings in XLV, the Top 10 holdings are slightly more heavily weighted.
In terms of the industry breakdown, I'd just like to feature one thing. Doubtless because VHT draws from mid- and small-cap stocks, its weighting in Biotechnology is roughly 3% higher than in XLV; at 18.00% vs. 14.81%. This is potentially the fastest-growing segment of the industry, but the most volatile as well. The offset is mainly in Pharmaceuticals, where VHT's weighting of 27.80% trails XLV's 30.74% by roughly that same 3%.
Looking forward, and this can be seen in the opening graphic of this section from Hoya Capital Income Builder, VHT is currently a little more "expensive" than XLV, with a P/E ratio of 26.6 vs 22.6.
Summary and Conclusion
So what does this all mean?
To me, the most meaningful conclusion is that either of these ETFs are worthy of serious consideration for inclusion in your portfolio. As we face the uncertain future described in my previous article, the Health Care sector should hold up well in relative terms, as outlined in this article.
But which ETF should you choose? VHT, or XLV?
Before you make a final decision, take a look at the results of a backtest I ran, courtesy of Portfolio Visualizer. It's a simple comparison of the two ETFs, covering the period starting in January, 2005 through the present.
VHT vs. XLV: 2005-2022 Backtest (PortfolioVisualizer.com)
Based on everything I outlined in this article, I would have predicted that VHT might offer potential for superior returns, at the "cost" of slightly more volatility than XLV. Essentially, that is exactly what appears to have played out in the backtest.
Since, in my title, I promised to pick a winner, I will do so. For me, the winner is VHT, but only by the slightest of margins. If you lean slightly more conservative, and would like to stick with large-cap stocks, XLV makes an excellent choice.
For further details see:
VHT Vs. XLV: Picking A Winner In The Health Care Sector