Vanguard Healthcare Fund: 3 Things You Must Know Before Buying This Health Fund

By Markets Fool.com

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The Vanguard Health Care Fund (NASDAQMUTFUND: VGHCX) is one of Vanguard's best sector funds, beating the performance of the stock market average and its sector fund peers by investing exclusively in companies in the healthcare industry. But this fund may not be all it appears to be -- it's not a fund for hot biotech stocks, nor is it fund worth owning for a dividend.

Here's what you should know before investing in Vanguard's top medical mutual fund.

1. This health fund favors "safer" healthcare stocks

Vanguard's healthcare fund primarily invests in medium- and large-capitalization stocks in the global healthcare industry. More than 90% of its assets were invested in companies categorized as mid cap or larger at the time of writing.

This is not a particularly speculative fund. The fund tends to avoid small single-product biotech companies, and companies whose lives depend on a single FDA decision. If you're looking to make bold bets on biotech stocks, this certainly isn't the fund for that. Its largest holdings recently included plain-vanilla companies such asBristol-Myers Squibb, UnitedHealth Group, and Allergan, which combined make up about 19% of the portfolio.

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Avoiding the most speculative companies has proven to be a good strategy. Over the five- and 10-year periods ended Dec. 31, 2015, its performance easily topped the average global health and biotechnology fund.

Data source: Vanguard Group.

2. Fees are especially low for an active fund

The Vanguard Healthcare Fund is not a passive index fund like most of Vanguard's most popular funds. It is actively managed by Wellington Management, which acts as a subadvisor for many of Vanguard's largest and most successful actively managed mutual funds. Wellington can invest up to 50% of the fund's assets in foreign stocks, a necessary freedom given that many healthcare companies are domiciled outside the United States.

Vanguard aims to keep fees and expenses low, despite the fact that actively managed funds have higher operating expenses than passive index funds. Here's how its expenses stack up against two of its peers.

Fund

Expense Ratio

Vanguard Health Care Fund

0.36%

T. Rowe Price Health Sciences Fund(NASDAQMUTFUND: PRHSX)

0.76%

Fidelity Select Health Care Portfolio(NASDAQMUTFUND: FSPHX)

0.73%

Data sources: Vanguard, Fidelity, and T. Rowe Price.

Investors who are particularly concerned about expenses may prefer the Vanguard Health Care Index Fund (NASDAQMUTFUND: VHCIX). The fund tracks an index, and has put up returns that are similar to the actively managed Vanguard Health Care Fund, but with more volatility. The passive fund carries an annual expense ratio of just 0.10%.

3. Its dividend history can be misleading

Healthcare companies routinely use their excess cash to invest in research and development, and to acquire other companies in their industry. Higher dividend yields paid by a handful of established healthcare companies are offset by the microscopic yields of growth-oriented companies.

Data compiled by respected valuation expert Aswath Damodaran reveals that pharmaceutical companies yield about 2.8% on average. Growth-focused biotech companies yield just 0.7%, and broader healthcare products companies yield just 1.1%. For reference, the dividend yield of the S&P 500 is about 2% per year.

This is not an industry for large dividend yields, andhigh-dividend mutual funds typically invest less of their assets in healthcare for this reason. Unfortunately, financial portals frequently make a critical error when calculating mutual fund yields, reporting that health funds yield far more than they actually do.

In 2015, the Vanguard Health Care Fund paid out $17.97 in distributions per share to its investors, resulting in a reported yield of about 8%. However, of those distributions, only $2.61 was classified as "income," with the remainder categorized as long- and short-term capital gains. Many finance websites reported that the fund's dividend yield was in excess of 8%, although the true recurring dividend yield was actually closer to 1%.

Selling stock at a profit isn't a sustainable or recurring source of income, and investors should exclude capital gains distributions when calculating yields on mutual funds. But its high level of distributions is important information -- this fund is best held in a 401(K) or IRA to avoid taxes on its beefy distributions.

Does the Vanguard Health Care Fund fit in your portfolio?

Vanguard's healthcare fund compares very strongly against its peers in performance, low expenses, and good management. As with every sector fund, however, it is probably best kept to a small portion of your total portfolio.

Healthcare stocks make up about 14% of the Total Stock Market Index, so investing heavily in a sector fund can reduce your diversification and result in performance that deviates from the stock market average.

But if you simply want to spice up your portfolio with a little extra dose of healthcare stocks, the Vanguard Health Care Fund is a fine pick. It offers a rare combination of active management at an index fund price, a bargain that is hard to pass up.

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Jordan Wathen has no position in any stocks mentioned. The Motley Fool recommends UnitedHealth Group. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.