ETF Health Care Select SPDR continues to be attractive (XLV)

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The SPDR (XLV) healthcare sector holds the components of the S&P 500 that belong to the healthcare sector. The allocation to each stock is a modified market capitalization weighting. Over the past 12 months, XLV has returned a total of 14.96%, compared to 11.86% for the S&P 500 (SPY). Over the past 10- and 15-year periods, XLV has also posted an annualized total return higher than that of the S&P 500.

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Total return for XLV versus SPY. Returns for periods greater than 1 year are annualized (Source: Morningstar)

These results are particularly notable because XLV has a 10-year rolling beta of 0.84 against the S&P 500. The outperformance over the 10-year period corresponds to an alpha of 3.3% per year due to the beta (relatively ) weak. Given that many health care stocks tend to fall into the value category, one would suspect that the higher yield is associated with an overall inclination toward value. However, a 3-factor analysis (Fama-French) gives an alpha of 2.99% per year over this same 10-year period, suggesting that only a small part of the apparent outperformance can be attributed to value bias. .

The explanation for the strong returns in healthcare stocks certainly begins with the increase in inflation-adjusted spending. In 2020, per capita healthcare costs exceeded $12,500 per person. Health spending is also consuming an increasing percentage of GDP, rising from 12.1% of GDP in 1990 to 13.3% in 2000, 17.2% in 2010 and 19.7% in 2020. 2020 figures are skewed by COVID-related expenses, of course.

health expenditure


Health expenditure per capita in the United States over time (Source: Peterson-KFF)

As America ages, growth in demand for health care is essentially inevitable, so it is very difficult to envision a reduction in national health care costs. Similarly, since older people tend to vote more often, government policies are unlikely to restrict the consumption of healthcare resources.

By selecting only stocks from the S&P 500 and allocating them based on market capitalization, XLV’s top holdings are all household names. While most of XLV’s top 10 holdings are pharmaceutical companies, the largest holding is United Health (UNH). For readers who might be interested, I’ve analyzed several of these stocks on an individual basis (UNH on Feb. 24, for example).

XLV Fund

the morning star

Top XLV headlines (Source: Morningstar)

Implied market outlook for XLV

To form an opinion on XLV, I look at a type of consensus outlook calculated from option prices on this ETF. The price of an option on XLV reflects the market’s consensus estimate of the probability that the price of the stock will rise above (call option) or fall below (put option) a specific level (the price of exercise of the option) by the expiration of the option. By analyzing call and put option prices at a range of strike prices, all with the same expiration date, it is possible to calculate a probabilistic price prediction for XLV that reconciles option prices. This is called the implied market outlook and represents the aggregate consensus between buyers and sellers of options on XLV.

I have calculated the implied market outlook for XLV for the 3.5 month period from now until June 17, 2022 and for the 10.6 month period from now until January 20, 2023, by using options that expire on these two dates. I have chosen these expiration dates to provide an outlook into the middle of 2022 and throughout the year, specifically selecting expiration dates where there is more options trading volume. Options that expire in June and January tend to be active compared to other months.

The standard presentation of the implied market outlook is a probability distribution of price return, with probability on the vertical axis and return on the horizontal.

Implied market outlook

Geoff Considine

Market implied price return probabilities for XLV for the 3.5 month period from now until June 17, 2022 (Source: Author’s calculations using options quotes from ETrade)

The market’s implied outlook for XLV through June 17 has a fairly wide peak, and the maximum probability is for a price return of 4.9% for the next 3.5 months. The outlook also has a long negative tail, which means the market is willing to pay a premium for put options that protect against losses. In statistical terms, this outlook is negatively biased. The most likely results are positive returns, but the maximum potential losses are greater than the maximum potential gains. These properties correspond to what we expect from a fairly diversified portfolio. The equity risk premium usually provides gains, in return for which investors bear the risk of large, low-probability losses. The volatility calculated from this outlook for the 3.5 month period is 12% (annualized volatility of 22.2%).

To make it easier to directly compare the probabilities of positive and negative returns of the same size, I rotate the negative return side of the distribution around the vertical axis (see chart below).

Implied market outlook

Geoff Considine

Market implied price return probabilities for XLV for the 3.5 month period from now until June 17, 2022. The negative return side of the distribution has been rotated around the vertical axis (Source: Calculations by author using ETrade option quotes)

This view shows that the probabilities of positive returns are significantly higher than for negative returns of the same size over a wide range of most likely outcomes (the solid blue line is well above the dashed red line on the left half of the graph above). The probabilities of large negative returns are higher than for positive returns of the same size (the dotted red line is above the solid blue line on the right ⅓+ of the graph), but these results occur with low overall probability.

This is a bullish outlook for XLV for the next 3.5 months.

The implied market outlook for the 10.6 month period to January 20, 2023 is qualitatively similar to the shorter period, although the 10.6 month period looks more optimistic. The maximum probability corresponds to a price return of 6.5% and the volatility for this period is 20% (annualized volatility of 21.2%).

Implied market outlook

Geoff Considine

Market implied price return probabilities for XLV for the 10.6 month period from now until January 20, 2023. The negative return side of the distribution has been rotated around the vertical axis (Source: Calculations by author using ETrade option quotes)

As a simple measure of most likely return versus risk, I look at the ratio of maximum probability return with standard deviation. For the 3.5 month period, this ratio is 41% (4.9% / 12%). For the 10.6 month period, this ratio is 33% (6.5% / 20%). These ratios are slightly higher than what I calculated for the tech sector’s SPDR in early February, but lower than what I tend to see for more diversified index ETFs.

The market’s implied outlook through mid-2022 and early 2023 looks reasonable and indicates that the consensus among option buyers and sellers is that XLV presents a reasonable risk-reward value proposition. The expected volatility, at around 21.5% (annualized), is somewhat higher than the trailing annualized volatility (15.6% and 14.7% for the 3 and 5 year periods, respectively). ETrade calculates an annualized implied volatility of 20% for options expiring in January 2023 (Source:, which supports the outlook for higher volatility.


S&P 500 healthcare stocks have long outperformed, especially on a beta-adjusted basis. The narrative supporting the strong growth of this sector is simple. The US population is aging and older people tend to consume more health care. It is difficult for me to envision a likely scenario in which this growth would disappear. Healthcare stocks, with some notable exceptions like MRNA, have also been less impacted than other sectors by the speculative fury of recent years. This, in turn, means there are fewer healthcare companies with incredibly bullish valuations that require perfect execution to justify themselves. The healthcare industry will face challenges in the coming years, of course, and many of them will involve constraints on product pricing. Reducing pharmaceutical costs is an issue with bipartisan support. The implied market outlook for XLV is slightly bullish, but expected volatility over the next year is higher than historical volatility. The market’s implied outlook seems consistent with the general narrative for healthcare stocks: generally positive outlook with higher risks than in recent years. I assign a bullish overall rating to XLV.

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