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1 June 2014 CFA Institute Journal Review

Health Care Investing: Is a Higher Dose of Health Care Good for the Portfolio? (Digest Summary)

  1. Martin A. Wildy, CFA

Based on their examination of how the health care industry has performed over time relative to other industries, the authors suggest that investors consider a larger allocation to health care stocks within equity portfolios.

What’s Inside?

By studying the health care industry’s risk-adjusted returns, changes in capitalization, and correlation with the broad market over a period of time, the authors analyze the industry as an investment opportunity. They reach four primary conclusions: (1) The industry, having grown to represent 15% of US spending, is worthy of a separate allocation; (2) its correlation attributes enhance portfolio diversification; (3) health care stocks provide significantly positive risk-adjusted returns; and (4) inclusion of these stocks expands the attainable set of portfolios beyond those available using other major industries.

How Is This Research Useful to Practitioners?

Health care spending represented 17.6% of US GDP in 2009 and is projected to grow faster than the overall economy through 2020. Health care–related consumer price indices started to outpace other major consumer price index components in 1984–1985, and the cost gap has widened since. In addition, demand for health care services is increasing as a result of evolving diagnosis technologies and the treatments associated with an aging US population. This demand is relatively inelastic and nondiscretionary. The authors believe that this combination of factors will lead to larger, or at least sustained, industry profits.

Health care’s share of market capitalization has increased dramatically from less than 2% in the 1930s to almost 13% in the most recent decade. Despite this increase, health care has received less scholarly attention than other industries. Health care stocks have outpaced the market by 16 bps per month (bpm) since 1926 and 22 bpm since 1985. After accounting for beta, size, value, and momentum factors, health care has earned an excess return of 32 bpm (3.84% annually) since 1985, a substantially higher figure than that of the other major industries. In addition, health care stocks have provided a lower correlation with the broad market. For the 25-year period ended December 2009, health care stocks had a correlation of 0.7 with the broad market, lower than that of any of the other industries the authors examine. As a result, mean–variance optimization favors an allocation to health care stocks.

This research will be of interest to investors seeking to gain a historical perspective on the relative performance of the health care sector, as well as professionals engaged in manager assessment and selection. Strategies that have been materially overweighted in health care stocks have structurally benefited over time, which may warrant consideration as part of a performance evaluation.

How Did the Authors Conduct This Research?

The data include the returns of the health care industry for the period beginning July 1926 and ending December 2009. The market the authors study consists of five industries as defined by Fama and French (Journal of Financial Economics 1997): health care firms, consumer firms, manufacturing firms, high-technology firms, and other firms. The authors use value-weighted monthly returns for all industries in addition to industry returns for the following market risk factors: small minus big, high minus low, and momentum. These data are downloaded from Ken French’s data library. Inflation-related data are obtained from the St. Louis Federal Reserve Economic Data (FRED) database.

The authors analyze performance for the entire period (1926–2009) as well as for past (1926–1984) and current (1985–2009) periods. They also look at the data over rolling 36-month periods. They address risk-adjusted performance by using a single-factor capital asset pricing model and the four-factor model (the three Fama–French factors and the Carhart momentum factor). The authors provide examples of beneficial trends for the health care industry but do not discuss why these generally well-known trends are not effectively priced by the market.

Abstractor’s Viewpoint

The authors provide an interesting overview of the relative outperformance of health care stocks over a period spanning more than 80 years. They argue that health care stocks represent a worthy investment. With health care being a major sector that is well-represented in most equity portfolios, I am not sure that investors are as unaware of the benefits of health care stocks as the authors imply. I would like to see a stronger rationale for why investors should expect these historical advantages to persist going forward. It would also be interesting to evaluate whether there has been uniformity within this sector or whether outperformance has been driven by certain subindustries.

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