Healthcare ETFs See Modestly Higher Valuations

The Health Care Select Sector SPDR (XLV), the largest exchange-traded fund (ETF) tracking the healthcare sector, finished the third quarter on solid ground with a gain of about 3%, pushing its year-to-date gain to over 18%. That cements healthcare's status as this year's second best sector behind only technology. What investors need to monitor in the healthcare sector going forward are valuations, which, although not alarmingly high, are creeping higher.

"In aggregate, valuations in the healthcare sector have slightly increased to a price/fair value of 1.02, up from 1 at the end of the last quarter and 0.87 at the start of the year as solid clinical data and the falling risk of higher payer pressure on branded drug prices are helping drug stock valuations," said Morningstar in a recent note. (See also: Why Drug Stocks Will Outperform the S&P and Dow.)

Interestingly, valuations for the broader healthcare sector are inching higher at a time when biotechnology stocks are, broadly speaking, inexpensive relative to historical norms. This is a relevant factor to consider because, know it or not, investors embracing diversified healthcare ETFs such as XLV are making indirect biotechnology bets. Biotech stocks usually account for 20% or more of broad healthcare ETFs like XLV.

A more sanguine political environment, meaning Republicans' ongoing failures to repeal and replace the Affordable Care Act (ACA), is also seen benefiting healthcare stocks. "Despite Republican control of the U.S. government, the failure to repeal the Affordable Care Act means the government is likely to focus on smaller healthcare changes," said Morningstar. "Overall, we find this development positive for the managed-care and hospital sectors as volume increases due to expanded coverage will remain in place." (See also: Goldman Sachs Concludes Obamacare Added 500k Jobs.)

XLV allocates 19.1% of its weight to healthcare providers and related services firms, but the ETF devotes a combined 55.5% of its weight to pharmaceuticals and biotech stocks. XLV's price-to-earnings ratio of just over 17 is below the 19.2 found on the S&P 500. "On the innovation front, drug and biotech companies continue to generate impressive data, supporting the moats of several key companies," according to Morningstar. "The new advances in cardiology, oncology and immunology are rapidly changing the treatment paradigms."

Interestingly, for the week that ended Sept. 28, investors pulled $683.2 million from XLV. During the third quarter, the ETF lost nearly $159 million in assets, trimming its year-to-date inflows to $1.74 billion.