XShares’ newest ETF: HealthShares

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“Slicing and dicing” is the order of the day in exchange-traded funds. Traditionally, ETFs have been about offering a way to trade in the big indices – notably the S&P 500 (through “Spiders”) and the Nasdaq 100 (through “the Qs”). But new offerings are now mostly based on specially drawn-up new indices, which allow investors to make ever more specialised trades.

This is a shift in the way ETFs are intended to be used. Buy the Spider and you have as pure a “beta” play as you can imagine – in other words, you are buying very direct exposure to the broad market. The new breed of ETFs are designed to help you find “alpha” – returns uncorrelated to the market. Even though the funds remain essentially passive, staying invested in them can provide alpha if they involve very specific sectors that are not greatly affected by the main currents in the economy.

One of the most arcane offerings, launched this year by XShares, a new New York-based specialist provider of ETFs, is a series of so-called HealthShares. These allow for specific exposures to sectors of the pharmaceuticals industry. Each caters for different illnesses or conditions.

A mere listing of the funds on offer might make many people feel queasy. The first nine to be launched included: metabolic-endocrine disorders; autoimmune-inflammation; cancer; cardiology; gender health; respiratory/pulmonary; neuroscience: and ophthalmology.

These ETFs offer macabre opportunities. An investor might, for example, sell cancer short while taking a long position in respiratory and pulmonary diseases. Do they offer you the opportunity to beat the market?

Each has a portfolio of between 20 and 25 stocks, mostly in relatively small companies. The median market value of companies in most of the ETFs is less than $2bn. Although the ETFs are listed in the US, their portfolios can go further afield, and include several European companies. This is appropriate given that healthcare is one of the most truly global of all industries.

This is not a value play. The companies involved tend to have very low dividend pay-outs (the cancer ETF has a dividend yield of only 0.06 per cent). And, in keeping with a fund that is trying to beat the market, it charges a higher fee than passive index funds. Annual charges are 0.75 per cent.

However, there is a clear logic to the offering. The growth potential of pharmaceuticals companies is obvious. A good understanding of the state of medical research can lead to clear judgments on which sector will see the next breakthrough. But often there may be only one big “winner” in a sector – the company that makes the breakthrough may make money on a scale that dwarfs that of the rest of the industry. So although investors will need very specialised knowledge of the industry to dabble in these funds, they still have a strong incentive to avoid taking the risks associated with investing in individual stocks.

At Exchangetradedfunds.com’s annual awards ceremony in New York, Jeffrey Feldman, XShares’ founder, said that by sorting the sector into narrowly targeted groups, “we give investors an opportunity to express an opinion over which areas will outperform”. This seems logical.

XShares also appears to be taking a position in a growing debate within the ETF industry, by using “fundamental” indices. In other words, their indices are not weighted by market value. Feldman does not apologise for this. In an industry with stable demand, he says, weighting by market value makes sense.

In an industry subject to swings such as pharmaceuticals, he said, it does not. The companies start with an equal weighting and will be rebalanced regularly. The brief history of HealthShares already suggests that this makes sense. Onyx Pharmaceuticals doubled its share price in one day at the end of February, meaning that it now takes up more than 10 per cent of the cancer fund. With good news already embedded in its price, it would be unwise to leave it with such a big weight in the fund.

HealthShares have only been trading since the middle of March, so no weight at all should be put on their performance to date. However, they have already shown the capacity for different pharmaceuticals sectors to perform very differently over short periods of time, and for sharp rises. This recommends them as vehicles for alpha-hunting investors who want to make returns uncorrelated with the markets, and willing to trade regularly.

After 42 days of trading, the cancer, endocrine, and pulmonary disease ETFs were on course to double in their first 12 months. The cancer ETF gained 18.5 per cent in its first six weeks of trading (equivalent, if it continued at this rate, to a 336 per cent annual return). The endocrine health ETF, meanwhile, gained only 9.7 per cent.

Returns like that suggest that XShares and its backers may well have found a product for which there will be a demand. Private investors, however, should almost certainly avoid it, unless they have genuine expertise in the state of developments in medical research.

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