Wednesday, May 11, 2005

Barron's Online - Health Fund Pro Bets on Biotech and HMOs

Barron's Online - Health Fund Pro Bets on Biotech and HMOs

It is interesting to see portfolio managers within a sector trying to ride two horses at the same time. Within any sector, there are always stocks that will perform relatively well in different economic environments. The classic example is food stocks.

Investors might be quick to assume that food stocks are defensive in nature; that they perform relatively well during economic tough times. The problem is there are several kinds of food stocks. Take the difference between grocery stores and restaurants. During tough times, traffic at Red Lobster, Olive Garden and Smokey Bones might die. DRI would not be the stock you want to own. On the other hand, Kroger may sell more groceries at higher margins during tough times.

One can certainly argue that it is wise to be diversified but, at some point in time, investors should know what they like and make a "bet" on it. John Maynard Keynes, one of the greatest investors of all time, said something like, "With perfect diversification, one will make zero profit".

A number of studies have been done over the years that show that 80% of managed mutual funds under-perform the market. Two of the authors of such studies are David Dreman and James O'Shaughnessy. A number of university professors have come to the same conclusions.

Something like 90% of the funds that did outperform the market did so by only 1% or less. Another interesting point is that if all you want is a basket of stocks in the health care business, you can buy an exchange traded fund and save the management fee! The total fees add up over time and the average under-performance is roughly equivalent to the total of the fees charged.

Heath Care stocks display the same dualism of food stocks. It makes sense that if drug companies are raising rices sky high and making lots of money, that hospitals which buy lots of drugs are having a tough time making money. It is the job of the investor to decide which is the best place to be. It is certainly possible that a drug stock and a hospital stock are both screaming buys at the same time. I am simply saying that there are millions of Americans paying hefty management fees to mutual funds that are no more than hidden index funds.

Random Roger posted a similar point this morning. He noted that Rydex is offering yet another big cap index. The fund admitted that the new fund has a .98 correlation to similar existing funds; who needs another? My suspicion is that institutional players are trying to unload these extra heavy stocks in order to increase beta now that the market is moving.

By the way, Professor Jeremy J. Siegel makes some great points about index funds. One is that "hot stocks" are added only after they have soared in value. He uses Yahoo as one of the great examples. The index did worse than it otherwise would have if Yahoo had not been added near the top.

The bottom line is that ETF's are often available to substitute for mutual funds to avoid management fees. Furthermore, a portfolio of 15 to 25 stocks will perform in line with any benchmark fund and there are no carrying costs.

My family generally avoids mutual funds. We occasionally buy ETF's to fill a diversification role. If we sell real estate, we may plop the money into an ETF temporarily. As we find good values in stocks, we swap out the ETF. In other words, we sometimes use an ETF as a very volatile money market account. Commissions are so low now-a-days that we are likely to make extra money even when we only hold the fund for 90 days or less (stocks go up something like 57% of the average month).