Health Care, Thinly Sliced

The health-care market already tops $2 trillion, and it just keeps growing. Its expansion continues without regard for the ups and downs of the overall economy, driven by aging baby boomers in the U.S. and an increasingly affluent population worldwide. With health-care investments' long-term prospects looking ever more appealing, new ETFs have arisen, providing increasingly specific and varied ways to invest in this booming market.

Among the more than 20 health-care ETFs currently available, many are broadly based within the health-care market. But others now focus on biotechnology or the pharmaceutical areas, or take an even more granular approach, specializing in cardiac devices or patient-care services.

Broad-based funds
Of the nine broadly based health care ETFs, most are fairly new. The Health Care Select Sector SPDR (AMEX: XLV) is one of the old-timers, having debuted in late 1998. Its $1.8 billion in assets track the Consumer Services Select Sector Index, with an expense ratio of 0.24% and a 1.3% yield. Large-cap companies compose more than 89% of its assets. The fund was up 7.1% in 2006 -- a good showing for this sector, but a middling return compared to the overall market.

Biotechnology funds
The five health-care biotech ETFs earned lackluster returns in 2006. The PowerShares Dynamic Biotech & Genome (AMEX: PBE) was the best performer of the group, with a return of just more than 2%. Since its inception in June 2005, the fund has a total return of 12.87%, and a moderately high 0.64% expense ratio.

The fund tracks the Dynamic Biotech & Genome Intellidex Index, which uses proprietary methods of stock selection and portfolio construction to identify 30 stocks in the biotechnology and genome industries on a quarterly basis. At the beginning of 2007, the fund had 42% of its assets in small caps, and roughly 55% in mid- and large-cap stocks combined.

Pharmaceutical funds
The pharmaceutical area offers investors four ETF options. PowerShares Dynamic Pharmaceuticals (AMEX: PJP) is one of the best pharmaceutical ETF performers; in 2006, the fund had a 10.8% return. With a 0.66% expense ratio, this fund tracks the Dynamic Pharmaceuticals Intellidex Index. It keeps 55% of its assets in large-cap securities, with 14% and 31%, respectively, in medium and small caps. Its top 10 holdings account for nearly half of its assets.

Pharmaceutical companies have recently suffered from a number of issues, including patent expirations, the threat of generic drugs, and a dearth of new products in the pipeline. But potential consolidation in the industry could drive overall returns higher.

Narrowly focused options
Five new health-care-focused ETFs, the HealthShares family, were launched in late January 2007. Together, they've sliced this market so thin that it's nearly become translucent. These new funds were created by XShares Advisors LLC of New York, and the indices they follow are aimed at the middle of each of their respective markets, eliminating the whales and minnows. Each index includes 20-25 stocks, so don't expect a widely diversified fund. The HealthShares funds range from the self-explanatory HealthShares Cardio Devices ETF (NYSE: HHE) to funds that concentrate on diagnostics, treatments for emerging cancer, enabling technologies, and patient-care Services. XShares plans to introduce a total of 20 HealthShares ETFs, making the health-care ETF market even more crowded.

The funds have a relatively high 0.75% expense ratio, which would be even higher except for a 0.34% waiver. Since these new ETFs could be very volatile, they should be considered a speculative investment. The HealthShares funds do have the advantage of investing in midsized health-care companies, providing investors exposure to some companies that otherwise might not appear in their portfolio unless purchased individually.

Picking stocks in such specialized areas of the health-care industry can involve a great deal of risk and require in-depth knowledge of the companies. The stocks of health-care companies can also experience severe swings in price -- from the approval or denial of a drug or medical device, for example. The Xshares funds could help smooth this wild ride somewhat.

Boomer care
Aging baby boomers and healthcare ETFs could represent a winning combination. The boomers' longevity, desire, and ability to improve their health contributes to the inelastic demand for health-care products. These are all positive and powerful reasons for investing in this sector.

Nonetheless, the health-care sector has yet to sort out the potential impact of a rising Democratic tide in Washington, which could make these funds volatile. Returns in general have not been exciting lately; that could either be a sign of potential or continued pain. For patient investors able to afford the risk of investing in a concentrated sector, this may be fertile ground.

Fool contributor Zoe Van Schyndel lives in Miami and enjoys the sunshine and variety of the Magic City. She does not own any of the funds or stocks mentioned in this article. The Motley Fool has a disclosure policy.