Health Care mutual funds invest in anything remotely related to health care. The companies represented in the portfolios of Health Care funds range from pharmaceuticals to hospitals and everything in between, and companies providing specialized services to health care providers also are represented.

Health Care funds provide a healthy dose of pharmaceuticals, which are quite often the largest holdings in these funds’ portfolios. The next largest would probably be hospitals and other care facilities. Then you will find varying amounts of general hospital equipment, specialized diagnostic equipment, software, health insurance, etc. They also invest in companies that specialize in developing new therapies, many of which would fall in the biotechnology subsector.

The interest in this sector stems from three factors: 1.) As our population ages and life expectancies lengthen, there will be increasing demand for health care and elder care. 2.) The demand for health care is relatively inelastic and thus provides a hedge against market declines. 3.) The cost of health care is rising much faster than inflation, which is thought by some to translate to greater profitability in the Health Care sector. It does, however, make Health Care a candidate for a hedge against inflation, or at least that portion of it attributable to disproportionate increases in the cost of health care.

There are many prognosticators who have and continue to tout these factors as good reasons to over-weight your portfolio in the Health Care sector. But the sector’s historical returns through 2007 don’t bear this out. Although the Health Care sector’s 10-year average return was nearly twice that of the S&P 500, it was an unusually bad period for the S&P 500 and the Health Care sector’s return was approximately equal to the long-term average of the S&P 500 but with slightly greater volatility. The sector’s 5-year return was about the same as the S&P 500 in both absolute and risk-adjusted returns. There are, however, some funds that consistently outperformed the market, both in absolute and risk-adjusted terms, over the past 10 years. If you decide to add a Health Care fund to your portfolio, pick one whose long-term performance identifies it as a probable winner going forward.

The sector was moderately correlated with S&P 500 over the past 10 years but the degree of correlation was significantly higher over the past five years. Thus the potential of Health Care mutual funds as a diversifier is very limited based on the past five years.