The Best ETF for 2007: H&Q Life Sciences Investors

As American baby boomers age, I can't think of a higher-growth industry than health care. As I learned from The Motley Fool's new special report on the baby boom generation, the U.S. currently spends about $2 trillion per year on health care. Over the next 10 years, national health-care spending is expected to double, outpacing the growth of wages, inflation, and the U.S. economy as a whole. By 2016, the U.S. will spend more than $10 billion per day, or $4 trillion per year, on health care. More than $1 out of every $5 spent in the U.S. will go toward medical costs!

Biotech is the crown jewel of the health-care industry, harnessing nature's own life processes to cure what conventional chemical-based drugs cannot -- the most intractable of human illnesses, including cancer, other genetic disorders, and perhaps aging itself. Don't forget agricultural biotech, either; it promises insect-resistant food crops and healthier snack foods.

Given the gale-force demographic winds in favor of health-care and biotech growth, I believe the best ETF for 2007 and beyond is H&Q Life Sciences Investors (NYSE:HQL). And there's a twist -- this biotech ETF pays an 8% annual dividend! Biotech stocks normally don't pay dividends, but this ETF pays out 2% of its net asset value each quarter, primarily out of realized capital gains (which may increase your tax bill).

Too much volatility to pick individual stocks
Although strong future growth is virtually assured for the biotech industry as a whole, investing in individual biotech stocks is a roller-coaster ride of speculative stock jumps and devastating crashes. Two recent examples of negative volatility: Neurocrine Biosciences (NASDAQ:NBIX), which plunged 62% on May 16 when the FDA delayed final approval of its insomnia drug, and Renovis (NASDAQ:RNVS), which crashed 76% on Oct. 26, when its stroke drug failed to demonstrate adequate efficacy in a late-stage clinical trial. Like I said -- it's a minefield.

It's nearly impossible for the average investor to separate the winners and losers among biotech stocks. If there ever were a reason to invest in ETFs, biotech is it. ETFs allow an investor to diversify among several stocks in order to reduce risk, and such diversification is most critical in the biotech space.

All ETFs are not created equal
Why am I not recommending Biotech HOLDRs (AMEX:BBH) or iSharesNasdaq Biotechnology (AMEX:IBB)? Neither pays an 8% dividend yield, for one thing; Biotech HOLDRs' dividend is minuscule, and iShares Nasdaq Biotechnology doesn't pay one. Secondly, these two ETFs are not well-diversified. Take a look at the top-heavy holdings of these two funds, compared with H&Q Life Sciences:

Top Holdings (% of Portfolio)

Not only is H&Q Life Sciences more diversified in terms of public equities, but its charter also allows the fund manager to invest as much as 40% of assets in private equity, convertibles, and warrants -- potentially higher-profit asset classes, which are normally off-limits to all but the most sophisticated and affluent investors.

The proof is in the returns
H&Q Life Sciences is not an index fund; it's actively managed by Daniel Omstead, a Ph.D. in chemical engineering and applied chemistry with significant work experience at Johnson & Johnson and Merck. Over the long term, his informed stock-picking should handily outperform the general market, as history has shown over the fund's past few fiscal years:

Total Return % (including dividends)

Over the past six months, the fund has underperformed, causing its share price to currently trade at a 7% discount to the fund's net asset value (NAV). In essence, you're now able to buy $1 worth of high-quality biotech stocks for $0.93. Did I mention that portfolio manager Omstead purchased $21,000 worth of the shares for himself back in September, his first purchase in 18 months?

You heard correctly: H&Q Life Sciences, a health-care fund investing in one of the highest-growth sectors of the U.S. economy, is trading at a discount to NAV. Consequently, it's now primed to be the best-performing ETF for 2007.

Is H&Q Life Sciences Investors the ETF investment for 2007? I sure think so. If you agree with my position, let us know by participating in our brand-new community intelligence database, Motley Fool CAPS. All you need to do is rate HQL "outperform." To make your voice heard, click here.

Go here for the complete list of ETF contenders in our CAPS tournament. And for more information on exchange-traded funds, visit the Fool's ETF Center .

Jim Fink does not own any shares in the companies mentioned. The Motley Fool is investors writing for investors .