Health-care stocks, particularly those of the big pharmaceutical companies, have long been considered defensive plays when interest rates are rising. Normally, when the U.S. Federal Reserve boosts rates, as it has continued to do, the economy slows, dragging down corporate profits and stock prices. But the number of sick people doesn’t decrease when the economy slows, so investors generally favour drug stocks in tough times. And to do so means looking across the border because there are so few options in Canada.

On the theory that such diversification is even more important these days, two broadly based health-care funds to consider are CI Investments Inc.’s $239-million CI Global Health Sciences Fund and the $1-billion Talvest Global Health Care Fund from CIBC Asset Management Inc.

Like many of their global peers, both funds have provided modest absolute results in the past five years, in large part because of a steadily appreciating Canadian dollar. The fact that there seems to be relatively few new blockbuster drugs in the approval pipeline, coupled with concerns that U.S. health-care spending may be cut in the face of a growing budgetary deficit, has also kept the sector under pressure.

So it is not surprising that a 34.9% return in 2003 was the last big pay day for investors in this CI fund. Held back by weak performance following the crash of tech stocks, its average annual five-year compound return as of May 2006 was 3.3%, compared with the median fund’s average annual loss of 5.2%. But this still translates into a five-star risk-adjusted rating from Morningstar Canada.

Talvest Global Health Care, modelled on U.S.-based Vanguard Group Inc. ’s Vanguard Health Care Fund, which has been closed to investors for more than a year, has produced an overall five-year compound rate of return of 2.1%.

Since its inception nine years ago, however, its 18% annualized return doubles that of the next best fund in the category.

As a result, the fund has been acclaimed Health Care Fund of the Year for the past three years at the Canadian Investment Awards, also garnering five-star Morningstar ratings in the same period.

Edward Owens, lead manager of the Talvest offering, is a senior vice president at Wellington Management Co. LLP, where he has worked since 1974.

Prior to that, he was a nuclear engineer and submarine officer in the U.S. Navy.

Using a bottom-up fundamental value style in what is really a growth sector, Owens divides his universe into four areas — biotechnology, pharmaceutical, medical devices and health-care services — to strike a balance among each subsector based on several criteria, including new product outlook, competitive position and relative valuation.

Before assuming responsibility for the CI fund in 2000, Andrew Waight was a mid-cap specialist for BPI Mutual Funds. Prior to joining BPI in 1997, he managed Canadian small-cap portfolios at Mutual Asset Management.

A growth-at-a-reasonable-price approach takes Waight all across the sector.

When studying larger companies, he looks for solid established enterprises that are in the throes of an operational turnaround and alternates these with smaller companies that are strategically placed to take advantage of a particular medical trend.

The fund’s performance has recently been driven by names such as Biomarin Pharmaceuticals. This company already has two drugs on the market for rare amino-acid disorders. Acura Pharmaceuticals, which continues to make progress in getting its abuse-resistant painkillers — popular drugs such as OxyContin, even when used on a prescription basis, are often abused — is another favourite.

However, the fund’s largest and most successful holding, Imclone, the high-profile biopharmaceutical company at the heart of the Martha Stewart investigation, has been somewhat stagnant recently.

Significant holdings in the Talvest fund include Schering Plough, Vertex Pharmaceuticals, Shionogi, Parexel International, Daiichi Sankyo and Forest Laboratories. Vertex continued on its upward trajectory given strong enthusiasm for its hepatitis C virus drug.

Japanese Plays

Within Japanese pharmaceuticals, Shionogi benefited from a profitable royalty stream off sales of AstraZeneca’s cholesterol drug, Crestor. Investor confidence in the recently merged Daiichi Sankyo has been strong in response to the company’s developmental projects in diabetes, cancer and cardiovascular disease.

Both funds scour the health-care sector across various world markets. Currently, 72% of the CI fund is based in the U.S., with 9.3% in Britain, 7.6% in Australia and 5.7% in France. The Talvest fund has a slightly smaller (63%) weighting in the U.S. with another 16% in Japan, 5% in Switzerland and 3% in Britain.

@page_break@The Talvest fund generally contains more than 80 stocks — substantially more than the median fund in the category. Waight’s fund usually hovers in the range of 40-50. Owens’ portfolio is fairly diversified, with about 30% of the fund’s assets spread among the top 10 names.

Waight generally plants about half of his assets in his top 10 holdings, resulting in a much greater concentration for CI unitholders. Both funds include several small- to mid-cap names.

Despite their sector status, the two funds have few common holdings among their major choices. The one exception is the Sanofi-Aventis Group, the world’s third-largest pharmaceutical company, ranking No. 1 in Europe.

The CI fund is the more volatile of the two. For the past five years, it has had a standard deviation of 15.1, whereas the Talvest fund has a 12.8 standard deviation.

The funds’ respective Sharpe ratios indicate that CI supporters have been better rewarded over the five-year period, earning more money than unitholders in other, similar funds but with less worry. Longer-term, this ranking favours the Talvest offering.

Research by McLean & Partners, a Calgary-based financial advisory firm, suggests that the correlation between the Canadian energy sector and health care in the U.S. market is quite low. It found health-care stocks fell much less than energy companies during each major energy sector correction since 1999.

With this in mind, both these solid funds could provide much-needed diversification for many Canadian investors, as well as opportunities to bottom-fish in a sector that is under-represented in Canada.

The original Vanguard fund’s stellar record in the U.S. probably makes the Talvest fund the front-runner, despite its high 3.14 MER, which Morningstar describes as “downright shameful.” IE