Vanguard Health Care ETF: Healthcare Exposure Benefits (NYSEARCA:VHT)

Two doctors in hospital hallway discussing electronic patient record

Solskin

Thesis

While investors are hoping for a less turbulent second half of 2022, many are shifting their allocation strategy to include more defensive, non-cyclical positions. Healthcare is one of the few sectors that has proven over time its ability to resist sharp economic downturns, and in this analysis the Vanguard Health Care ETF (NYSEARCA:VHT) is examined, to decide if it represents the optimal way for gaining exposure in the sector.

Since the beginning of the year, the healthcare sector has recorded a -8.14% loss compared to the S&P 500’s -12.63%. With cyclicals and tech leading the downtrend, the inelastic demand for healthcare products and services should maintain margins close to desirable levels.

Chart
VHT data by YCharts

Healthcare Sector Outlook

The spread of the global Covid-19 pandemic has shifted a lot of attention back to a previously overlooked sector. While the importance of healthcare innovation, availability and affordability are undeniable, it is important to review the current challenges and trends facing the industry. Fighting Covid-19 still remains a prime focus for industry participants as supply-chain shortages coupled with outbreaks, especially in the Asia-Pacific region pose significant risks. Telehealth and remote patient monitoring are accelerating, potential growth-generating trends that have immerged in the past few years. Telemedicine applications aim to improve the efficiency, accessibility and cost-effectiveness of the healthcare system. At the same time, more emphasis is being directed towards incorporating AI solutions, personalized care services, and less evasive procedures in the modern healthcare industry.

With approximately 20% of GDP spending attributable to Healthcare, analysts expect increased spending to drive future growth. According to insiderintelligence.com, the U.S healthcare market size is expected to reach $665B by 2028, while the national healthcare expenditure is forecasted to increase from $4.1T to $6.2T. As Healthcare companies have finally accelerated their digital transformation, investors will be able to identify growth opportunities in a traditionally defensive sector.

Fund Overview

The Vanguard Health Care ETF seeks to track the performance of the domestic U.S healthcare sector. Through VHT, investors can obtain direct exposure toward healthcare companies, ranging from Biotechnology companies to Equipment and Services providers. The fund currently charges a 0.10% expense ratio and pays a 1.30% dividend yield.

Fund Composition

Within the Healthcare Sector, VHT is well-diversified across different industries. Pharmaceuticals represent the largest (and arguably most defensive) industry the exchange-traded fund (“ETF”) invests in, accounting for 27.50% of total weighting. The Biotechnology and Healthcare equipment industries follow, covering 17.10% and 17.30%, respectively. Other industries with substantial weighting include Healthcare Technology, Managed Healthcare, and Healthcare services. VHT’s largest holdings include familiar large-cap healthcare names like UnitedHealth Group (UNH), Johnson & Johnson (JNJ), Pfizer (PFE), Eli Lilly and Co. (LLY) and others.

Fund Composition

Vanguard

Performance Analysis

As the markets experience significant turmoil, many investors have rushed to increase their exposure to defensive sectors of the economy. While these sectors that include Healthcare, Consumer Staples and Utilities have received increased attention, many long-term investors have been using defensive positioning prudently for many years now, even through prolonged bull markets.

Employing the tools offered by Portfolio Visualizer, I examined how the addition of defensive exposure could affect the return and risk profile of a broader-market portfolio over time. Three portfolios were constructed for the purposes of this analysis. Portfolio 1 is invested solely in an S&P 500 ETF, Portfolio 2 allocates 60% to the S&P 500 and 40% to the healthcare sector, and finally, Portfolio 3 involves a 60% investment in the S&P 500, 20% in the Healthcare sector and 20% in the Consumer Staples sector. A $10,000 initial investment, annual rebalancing and dividend reinvestment are assumed in the backtest.

Despite the defensive, non-cyclical nature of the additions of Healthcare and Consumer Staples, both alternative portfolios seems to outperform the market both in terms of risk and return metrics. Portfolios 2 and 3 record a 0.50 Sharpe ratio, compared to the market’s 0.42, while recording higher annualized returns at 7.89% and 7.60% respectively, compared to 7.16% for the S&P 500 ETF. They also record lower drawdowns and standard deviation. Of the two alternative portfolios, the one that only adds Healthcare exposure performs slightly better.

Allocation Backtest

Portfolio Visualizer

It is important to note that, while the reference period (1998 – present) contains some strong, prolonged bull markets, it also measures performance during two major market crashes (2008 and 2020) while also depicting the aftermath of the tech bubble in the late 90s. In fact, the lower deviation and drawdown metrics that portfolios 2 and 3 display, arguably prove that defensive positioning can be very prudent during times of uncertainty and instability in the markets.

VHT vs XLV

When it comes to investing in the Healthcare sector, basically 2 popular choices are available for retail investors: the Health Care Select Sector SPDR (XLV) and, of course, VHT. XLV is by far the more popular of the 2 (also the older one), with approximately $40B in AUM, compared to VHT’s $17B. Both ETFs charge a relatively low, 0.10% expense ratio. XLV offers a slightly bigger dividend, with a 1.45% yield compared to VHT’s 1.30%.

As far as fund composition is concerned, the top 5 holdings remain the same for both ETFs (UnitedHealth, Johnson & Johnson, Pfizer, Eli Lilly and AbbVie), even though XLV is a bit more concentrated in the sector’s large caps (top 10 holdings for XLV account for 54.8% of total weighting vs. 48.2% for VHT). Considering the fact that the Healthcare sector is very mature and growth is relatively slow, marginal gains could originate from smaller cap exposure. For this reason, VHT might appear as the preferable choice.

After diving into the return and risk performance of both funds, again with the help of Portfolio Visualizer, VHT appears to come out on top. The backtest performed goes back to January 2004 when Vanguard’s ETF was incepted. Dividend reinvestment is also assumed, in order to credibly measure total returns. Compared to XLV’s 9.99% CAGR, VHT records a superior 10.47% annualized return. An initial $10,00 investment in VHT would have yielded $63,144, while the same amount invested in XLV would have resulted in total equity of $58,225 for the 18-year period. In terms of risk metrics, VHT has a slightly higher standard deviation, yet a marginally lower maximum drawdown. Both the Sharpe and Sortino ratios, however, indicate that VHT delivers slightly better risk-adjusted returns.

ETF Comparison

Portfolio Visualizer

It is also important to mention that both Healthcare ETFs have surpassed the average annualized market return of 9.32% during the 2004-2022 period. While stronger growth performance has been recorded in the broader market compared to the Healthcare sector, especially in the last 10 years, the sector’s overperformance is likely attributable to its resilience during the 2008 and 2020 stock market crashes.

Final Thoughts

After all things are considered, exposure in the Healthcare sector is likely to provide both short and long-term benefits for investors. Even if the market recovers completely, involving Healthcare positions in a diversified portfolio still offers long-lived benefits. For this purpose Vanguard’s Healthcare ETF represents an attractive investment vehicle.

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