Healthcare ETFs' Check Up Ahead of Higher Interest Rates

The healthcare sector and the corresponding exchange-traded funds do not have the reputation for being comparably as sensitive to changes in interest rates as say utilities or real estate stocks. Nor are healthcare ETFs as positively levered to rising rates as financial services funds are.

During the Federal Reserve's 2004 through 2006 tightening cycle, the Health Care SPDR (ETF) (NYSE:XLV), the largest healthcare ETF by assets, offered slight out-performance over the S&P 500. That is to say, sector investors could have done better against the S&P 500 than they did with XLV, but they also could have done much worse.

Related Link: Biotech ETFs: Buy, Buy, Buy?

Biotech, Healthcare And Interest Rates

With the emergence of the biotech industry as a mainstream investment thesis and the subsequent inflows totalling in the billions to biotech ETFs in recent years, healthcare investors are undoubtedly pondering how biotech stocks and funds will be affected by higher interest rates.

As the economic recovery matures, some investors are looking for sectors and industries that could continue to deliver growth. S&P 500 Index earnings growth in Q3 is expected to be -4.4 percent; however, the health care sector is expected to grow EPS by over 7 percent, according to analysts polled by FactSet, according to a recent research piece by State Street Global Advisors (SSgA), XLV's issuer.

Despite some struggles earlier this year, the SPDR S&P Biotech (ETF) (NYSE:XBI) is up 14.2 percent year-to-date, which is more than double XLV's 2015 gain.

A Closer Look Into XLV And XBI

XBI, the third-largest biotech ETF by assets, debuted in January 2006, so the biotech ETF has not been around for a full Fed tightening cycle. In 2006, the last year of the Fed's most recent tightening cycle, XBI fell 6.3 percent, but XLV climbed 5.7 percent.

Related Link: Equal Weighting Works For This Industry ETF

XBI is an equal-weight ETF, a weighting methodology that has some advantages. One of those benefits is less skew to its top holdings. For example, XBI's top 10 holdings combine for less than 14 percent of the ETF's weight, according to issuer data, while some capitalization-weighted biotech ETFs devote close to 60 percent of their combined weights to their top 10 holdings.

Due to its tilt toward smaller biotech names, XBI has been the best-performing biotech ETF over the past three years; it has also been the most volatile.

Using the equal-weighted exposure provided by XBI may allow you to capitalize on these trends even more, since the fund contains a higher percentage of the mid- and small-cap companies most often targeted by the giants, according to SSgA.

This broad and diversified market cap profile of XBI creates an overlap of portfolio holdings, in terms of market cap, with the sector fund XLV of just 8 percent compared to 50 percent of market cap overlap of portfolio holdings for the NASDAQ Biotechnology Index to XLV.

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