Across asset classes and strategies, health care has become a highly prized sector. The industry's public stocks strongly contributed to this year's record-high market closes, and health-care companies have outpaced technology firms as private capital firms' targets based on deal flow. Within the hedge fund industry, health care has driven outsized results for specialized and dedicated managers.
At a high level, opportunities in health care are largely driven by new product innovation, regulatory and scientific complexity, and strong demographic trends. The sector is also catalyst-rich and event-driven in nature — including a large and growing number of clinical trials, drug approvals, and mergers and acquisitions — which makes health care less correlated to the overall market.
Innovation and disruption in the sector is unabated, and new drug approvals have increased as costs come down. The number of clinical trials has grown exponentially to 314,644 as of August, from 1,255 in 2000. M&A activity in the pharmaceuticals and biotech industries is widespread as "big pharma" companies acquire smaller biotech firms; in particular, within the fields of oncology and immuno-oncology.
Health care also continues to be a growing part of the U.S. economy. Health expenditure as a percentage of U.S. gross domestic product grew to 17.1% in 2018, from 12.5% in 2000. Health care also tops other industries in the initial public offering market. According to IPO research firm Renaissance Capital, the health-care sector has had the most IPOs by industry every year from 2014 to 2018, continuing apace through August. In 2018 alone, health care represented 40% of all IPOs and $9 billion in proceeds.
A growing number of health-care hedge funds are also taking advantage of private investment opportunities, either through co-investments, side pockets or separate product offerings. Many times, private investments are significantly increasing returns as funds can get involved at an early stage and leverage synergies between public and private research. Additionally, most hedge fund firms employ Ph.D.s and professionals from the medical industry, who help in analyzing the more nuanced and technical aspects of investments.
All of this activity is correlated with outperformance compared to other peer groups. We compared performance among our 40 strategy indexes containing more than 1,150 hedge funds, and health care has been the best performing peer group on a 10-, five-, three- and two-year rolling basis (as of May). Additionally, from an alpha perspective, health care generated the highest alpha of any strategy over both the last 24 months and five years, relative to our proprietary risk models.
Investing in health care is not just a beta play. A significant amount of the return is alpha-based, meaning that stock selection plays a vital role in determining hedge fund performance. Stock picking is especially important in the health-care sector given all the volatility and dispersion in the sector.
Breaking it down by subsector, there is also substantial dispersion within health care, creating a good environment for both long and short opportunities. For example, during the first half of the year, the best performing S&P 500 health-care GICS subsector is health-care technology, up 39.8%, while the worst performing subsector, health-care services, is down -10%. In 2018, the Health Care Facilities GICS index was the top performer at 30.5% while the Health Care Technology GICS index was the worst performer at -22.2%.
Over the last five years, nine of the 10 S&P health-care subsectors generated a positive CAGR with managed health care at the top with 21% and health-care distributors at the bottom with -3%. The S&P 500 Health Care index itself has a five-year CAGR of 8.8%, compared to 8.5% for the S&P 500.
However, the S&P indexes do not paint the full picture of performance in the sector. Notably, biotechnology stocks fared much better when looking at the Russell 2000 health-care subsector indexes, which are more small-cap oriented. The Russell 2000 Biotechnology index is up 24.2% (as of June 30) and has a 10.8% five-year CAGR. In comparison, the S&P Biotechnology GICS index is down -2.1% through June 30 and has a 3.1% five-year CAGR. The Russell 2000 Biotechnology index is more representative of actual hedge fund exposure and thus performance. From this standpoint, it is clear that small-cap biotech is additive to a health-care investor's portfolio.
Of course, investors should always assess investment strategies within the context of the macro environment. Given the importance of regulation within the health-care industry, as well as its high-profile role as a talking point in political discussions, the result of next year's federal elections could lead to regulatory changes in this industry.
Ultimately, as the data clearly demonstrates, health care generates consistent and compelling performance across numerous metrics. The backdrop for those opportunities has only increased over time.
I believe that long/short funds in health care have room to run.
Jonathan Caplis is CEO of PivotalPath Inc., New York. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.
