This Health Care ETF Wins With More Exposure to Smaller Firms

Exchange-traded funds that focus on health care stocks tend to tilt toward the titans—companies such as Johnson & Johnson (symbol JNJ), Merck (MRK) and Pfizer (PFE). Those stocks have their merits. But the companies aren’t growing rapidly. For that, you’ll need to invest in smaller firms with more dynamic growth potential.

Guggenheim S&P 500 Equal Weight Health Care (RYH), a member of the Kiplinger ETF 20, doesn’t play favorites when it comes to a company’s size. As its name implies, the fund holds 62 stocks in equal proportions, each about 1.6% of the portfolio. Businesses such as Mettler-Toledo—a precision-instruments firm with a market value of $16.1 billion—carry as much weight in the ETF as J&J, valued at $349 billion. The mix, says Guggenheim, reduces bias toward the health care giants and provides more exposure to smaller firms with potentially superior stock returns.

Equally weighting stocks has been a winning strategy for the ETF. Mettler, for instance, has gained a total of 514% over the past decade—three times as much as big drug companies such as J&J (returns are as of September 29). Stocks such as Mettler have powered the ETF to an annualized return of 12.6% over the past 10 years, beating the 10.9% gain of the S&P 500 Health Care index (which weights stocks by market value). Impressively, the ETF has outperformed the index even though it has a somewhat steep expense ratio of 0.40%.

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The ETF does have some drawbacks, one being meager dividends. Stocks in the fund yield an average of 0.9%, about half the health care industry average and well below what you can scoop up with a giant such as J&J (yielding 2.6%) or Pfizer (3.6%).

The ETF may also be a bit riskier than a health care fund secured by more weight in large companies. In 2016, the Guggenheim fund lost 4.5% (including dividends). That compares with a decline of 2.8% for the Health Care Select SPDR ETF (XLV), which ranks stocks by market cap and is tilted toward the heavyweights.

Overall, health care stocks look appealing. Many are benefiting from increased spending on insurance, medical devices and prescription drugs. That is helping a record proportion of companies beat analysts’ estimates for sales and profits. Yet the stocks as a group still look inexpensive, says Bank of America Merrill Lynch, which recommends the sector.

The big unknown, of course, is what to expect from the industry’s largest benefactor: Washington. Cuts in government spending on health care could lower revenues for hospitals, insurers and other firms. Analysts would then trim their sales and profit estimates, and the stocks could take a hit.

But even if Congress hits the brakes, spending growth would slow but not stop. The medical needs of an aging population will inevitably push up demand for health care, a trend that should make this ETF a long-term winner.