The Health Care sector ranks seventh out of the ten sectors as detailed in my Sector Rankings for ETFs and Mutual Funds report. It gets my Dangerous rating, which is based on aggregation of ratings of 22 ETFs and 82 mutual funds in the Health Care sector as of April 4, 2014. Prior reports on the best & worst ETFs and mutual funds in every sector are here.

Figures 1 and 2 show the five best and worst-rated ETFs and mutual funds in the sector. Not all Health Care sector ETFs and mutual funds are created the same. The number of holdings varies widely (from 20 to 292). This variation creates drastically different investment implications and, therefore, ratings. The best ETFs and mutual funds allocate more value to Attractive-or-better-rated stocks than the worst ETFs and mutual funds, which allocate too much value to Neutral-or-worse-rated stocks.

To identify the best and avoid the worst ETFs and mutual funds within the Health Care sector, investors need a predictive rating based on (1) stocks ratings of the holdings and (2) the all-in expenses of each ETF and mutual fund. Investors need not rely on backward-looking ratings. My fund rating methodology is detailed here.

Investors should not buy any Health Care ETFs or mutual funds because none get an Attractive-or-better rating. If you must have exposure to this sector, you should buy a basket of Attractive-or-better rated stocks and avoid paying undeserved fund fees. Active management has a long history of not paying off. Here’s the list of our top-rated Health Care stocks.

Get my ratings on all ETFs and mutual funds in this sector on my mutual fund and ETF screener. For more products, click here.

Figure 1: ETFs with the Best & Worst Ratings – Top 5

Screen shot 2014-04-11 at 9.46.35 AM* Best ETFs exclude ETFs with TNAs less than $100 million for inadequate liquidity.

Sources: New Constructs, LLC and company filings

Figure 2: Mutual Funds with the Best & Worst Ratings – Top 5

Screen shot 2014-04-11 at 9.44.09 AM* Best mutual funds exclude funds with TNAs less than $100 million for inadequate liquidity.

Sources: New Constructs, LLC and company filings

Seven mutual funds are excluded from Figure 2 because their total net assets (TNA) are below $100 million and do not meet our liquidity minimums.

iShares U.S. Medical Devices ETF (IHI) is my top-rated Health Care ETF and BlackRock Health Sciences Opportunities Portfolio (SHSSX) is my top-rated Health Care mutual fund. IHI earns my Neutral rating, while SHSSX gets my Dangerous rating.

State Street SPDR S&P Biotech ETF (XBI) is my worst-rated Health Care ETF and Rydex Series Biotechnology Fund (RYBOX) is my worst-rated Health Care mutual fund. XBI gets my Dangerous rating and RYBOX gets my Very Dangerous rating.

Figure 3 shows that 29 out of the 323 stocks (over 18% of the market value) in Health Care ETFs and mutual funds get an Attractive-or-better rating. However, only zero out of 22 Health Care ETFs and zero out of 82 Health Care mutual funds get an Attractive-or-better rating.

The takeaways are: mutual fund managers allocate too much capital to low-quality stocks and Health Care ETFs hold poor quality stocks.

Figure 3: Health Care Sector Landscape For ETFs, Mutual Funds & Stocks

Screen shot 2014-04-11 at 9.43.24 AMSources: New Constructs, LLC and company filings

As detailed in “Low-Cost Funds Dupe Investors”, the fund industry offers many cheap funds but very few funds with high-quality stocks, or with what I call good portfolio management.

Investors need to tread carefully when considering Health Care ETFs and mutual funds, as only a few are worth a look. No ETFs or mutual funds in the Health Care sector allocate enough value to Attractive-or-better-rated stocks to earn an Attractive rating. Investors would be better off focusing on individual Health Care stocks instead.

Eli Lilly & Co. (LLY) is one of my favorite stocks held by Health Care ETFs and mutual funds and earns my Very Attractive rating. LLY has grown profits (NOPAT) by 8% compounded annually over the past 9 years and maintained NOPAT margins of 20% or over for most of these years. LLY also has a return on invested capital (ROIC) of 17%, which puts it in the top quintile of all companies I cover. LLY has also earned positive economic earnings every year since 1998, and has a free cash flow yield north of 10%. Despite the strength of LLY’s underlying fundamentals, the stock still trades at ~$59/share, which gives the stock a price to economic book value ratio of 0.9. This ratio implies that the market expects LLY’s NOPAT to decline by 10% and never rise again. This expectation seems too pessimistic considering LLY’s reliable performance over the past 15 years. Investors should consider LLY for a long-term value bet.

Hospira Corp. (HSP) is one of my least favorite stocks held by Health Care ETFs and mutual funds and earns my Dangerous rating. Hospira’s profits (NOPAT) have fallen by 8% compounded annually since the company went public in 2004, and the company has a bottom-quintile return on invested capital (ROIC) of 2%. Moreover, HSP has a free cash flow yield of -2% and has generated negative economic earnings for the past two years. However, despite this inability to generate profits, it seems investors are still speculating on this stock. HSP currently trades at ~$43/share. To justify this price, HSP would need to grow profits by 24% compounded annually for the next 15 years. This seems awfully optimistic for a company that has failed to grow profits at all since its IPO. Investors should steer clear of HSP.

Figures 4 and 5 show the rating landscape of all Health Care ETFs and mutual funds.

My Sector Rankings for ETFs and Mutual Funds report ranks all sectors and highlights those that offer the best investments.

Figure 4: Separating the Best ETFs From the Worst ETFs

HCF4Sources: New Constructs, LLC and company filings

Figure 5: Separating the Best Mutual Funds From the Worst Mutual Funds

HCF5Sources: New Constructs, LLC and company filings

Review my full list of ratings and rankings along with reports on all 22 ETFs and 82 mutual funds in the Health Care sector.

André Rouillard contributed to this report.

Disclosure: David Trainer and André Rouillard receive no compensation to write about any specific stock, sector or theme.

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