To say that the healthcare sector is enormous would still be an understatement. Americans spent $3.3 trillion on healthcare in 2016 alone. That gargantuan figure amounts to more than $10,000 per person and nearly 18% of total Gross Domestic Product. The number only grow from there when you zoom out to include the rest of the world.

As staggering as these numbers already are there's ample reason to believe that they will continue to push higher from here. The world's population is gradually aging and there's a strong link between age and spending on healthcare. These reasons make the healthcare sector a must-own space for investors.

However, with hundreds of individual healthcare stocks to choose from, it can be a huge challenge to find the best healthcare stocks to buy. That's why using exchange-traded funds, or ETFs, to gain healthcare exposure can be the smart choice for many investors. 

WOrds stocks bonds and ETFs writting on blocks next to bills

Image source: Getty Images.

What is an ETF?

An exchange-traded fund is an investment fund that is bought or sold on a stock exchange. In many ways, they are very similar to a mutual fund or index fund. However, the big difference between the two is that ETFs can be purchased on the open market during normal business hours, just like a stock.

ETFs have been around for a few decades but they have exploded in popularity in recent years. To meet that demand, ETF providers have been pumping out new products that hold a huge range of assets such as stocks, commodities, or bonds.

Just like stocks, ETFs have ticker symbols associated with them. For example, the SPDR S&P 500 ETF Trust -- the largest ETF in the world with more than $275 billion in assets under management -- trades under the ticker symbol "SPY". 

ETFs and mutual funds are very similar to each other but they are a few distinctions that separate the two.

First, ETFs can be bought or sold at any time during the trading day. Mutual funds can only be purchased or sold after a trading day comes to an end and its price is based on the net asset value of the fund.

Second, most, but not all, ETFs track a particular index and are not actively managed. This fact lowers their operating costs, which generally makes them cheaper for investors to own. That often helps to improve an investor's rate of return over the long run.

Third, ETFs do not have a minimum investment amounts or sales load. However, investors often have to pay a commission to buy or sell them in the same way that they would if they purchased a stock on the open market. 

Finally, ETFs can create and redeem shares with in-kind transactions that are not considered sales. This fact helps them to avoid taxable events, which generally provides investors with a tax-efficient ownership structure. 

The benefits of ETFs

There are a number of reasons why investors have poured billions of dollars into ETFs in recent years, including:

  • Costs: The average ETF sports an expense ratio of just 0.44%, according to The Wall Street Journal. This means that having $10,000 invested in a fund will cost its owner just $44 in fees per year. Some ETFs even have expense ratios as low as 0.03%! By contrast, the average traditional index fund has an expense ratio of 0.74%, according to Morningstar. 
  • Tax efficient: Mutual funds need to constantly rebalance themselves toy accommodate shareholders who want to cash out. Fund managers also regularly sell some of their assets in order to buy others. Both of these processes create taxable events for shareholders. By contrast, ETFs can accommodate inflows and outflows with ease by creating or redeeming creation units. These units are a pool of assets that mimic the entirety of the ETF's investment exposure. This ability shelters ETF holders from capital gains tax when they hold the fund. However, they still have to pay taxes on any gains when they sell. 
  • Instant diversification: Just like mutual funds, ETFs provide investors with an easy way to gain broad-based diversification to the market. For example, buying the Vanguard Total Stock Market ETF gives investors a tiny ownership position in more than 3,600 companies. 
  • Transparency: Most, but not all, ETFs publish their holdings at the end of every single trading day, which makes it easy for investors to see which assets their money is going into.
  • Easy to use: ETFs can be purchased on the open market at any time. This means that investors can buy them through their regular brokerage account.
  • Advanced strategies: Just like stocks, ETFs can be optioned and shorted. These advanced strategies can be used to help an investor manage their overall risk profile. 

The downside of ETFs

ETFs are generally a great deal for investors, but there are a few downsides to owning them.
  • Commissions: Since ETFs trade on exchanges, buyers and sellers usually have to pay their brokerage a commission every time they transact. These costs can eat into an investor's return over time, espeically if they are buying and selling shares on a regular schedule. 
  • The bid/ask spread: Just like stocks, ETFs have two prices: a bid and an ask. Sometimes there can be a gap between these two numbers that causes investors to sell for a lower price than they wanted or buy for a higher price. This can be especially prevalent in niche ETFs that do not have a lot of liquidity. 

ETFs, in general, are a great investment vehicle for individual and institutional investors alike. That's why investors appetite for ETFs have exploded in recent years.

To put some numbers on how popular they have become, consider that ETFs held about $204 billion in total assets as of 2003. That number jumped to $3.4 trillion as of 2016, according to statista.

How do you invest in ETFs?

Investing in ETFs is a straight-forward process.

The first step is to open up a brokerage account and fund it with money. Investors can choose from many different brokers and some of the most popular ones are companies like Vanguard, Etrade, Charles Schwab, Fidelity, T.D. Ameritrade and more. 

It can pay to be picking when choosing a broker because some of them allow investors to buy or sell certain ETFs commission-free. For example, Vanguard and Charles Schwab both let investors buy or sell their own proprietary ETFs with no commission. Other big-name brokers strike up partnership deals with third-party ETF providers to offer investors commission-free trades on certain ETFs.

Once your account is funded it is time to start building a diversified portfolio. While there are literally thousands of ETFs to choose from it can make sense to start with funds that already extremely well diversified such as the Vanguard Total Stock Market ETF mentioned above.

After a diversified portfolio is in place it can make sense to start layering in extra exposure to portions of the stock market that you are particularly bullish on such as the healthcare sector.

Healthcare ETFs

There are more than 40 healthcare ETFs on the market today, so investors who want additional exposure to the industry have plenty of choices. 

Here's a look at the 10 most popular healthcare ETFs as measured by assets under management: 

Healthcare ETF

Assets Under Management

Expense Ratio

10-Year Average Annual Return

Health Care Select Sector SPDR(XLV 0.24%)

$19.7 billion

0.13%

16.4%

iShares Nasdaq Biotechnology (IBB 0.41%)

$9.3 billion

0.47%

18%

Vanguard Health Care ETF (VHT 0.20%)

$8.8 billion

0.10%

16.9%

SPDR S&P Biotech (XBI 0.19%)

$5.2 billion

0.35%

18.6%

iShares U.S. Healthcare(IYH 0.17%)

$3.3 billion

0.56%

22.6%

iShares U.S. Medical Device ETF (IHI -0.19%)

 $2.7 billion 0.43% 17.4%

iShares U.S. Healthcare ETF (IYH 0.17%)

 $2.4 billion 0.43% 16.3%

iShares Global Healthcare ETF (IXJ 0.24%)

 $1.8 billion 0.47% 14%

Fidelity MSCI Health Care Index ETF (FHLC 0.11%)

 $1.5 billion 0.08% N/A

First Trust Health Care AlphaDEX Fund (FXH 0.32%)

 $1.3 billion 0.62% 18.3%

DATA SOURCE: ETF.COM AS OF 10/11/18.

With so many choices, what's the best way for investors to pick which funds are most suitable for them?

Here are a few ways that these funds distinguish themselves from each other.

  • Broad exposure vs. niche focus: Some Healthcare ETFs own a huge number of healthcare companies. For example, the Vanguard Health Care ETF owns more than 370 individual stocks that operate industries like biotechnology, healthcare equipment, healthcare facilities, life sciences too, pharmaceuticals, and more. Other funds, such as the iShares Nasdaq Biotechnology take a much more narrowed focus and allow investors to place a more concentrated bet. 
  • Equal weight vs. sector-weight: Some ETFs use a market-cap weighted methodology to determine how big each individual stock position in the fund should be. For example, the iShares Nasdaq Biotechnology has about 40% of its assets allocated to the biggest names in biotechnology. By contrast, the SPDR S&P Biotech ETF uses an equal-weight methodology that rebalances its holdings quarterly to ensure that no position becomes outsized.
  • Costs: The Vanguard Health Care sports a dirt cheap expense ratio of just 0.10%. By contrast, the iShares U.S. Healthcare ETF's expense ratio of 0.56% is literally five-times more expensive to own each year.
  • Commissions: As mentioned above, some brokers allow their clients to buy or sell ETFs for free while others charge a commission.

Top Healthcare ETFs to consider

1. The Vanguard Health Care ETF

For investors that want broad-based exposure to the healthcare sector for a dirt cheap price, it's hard to beat the Vanguard Health Care ETF. This market cap-weight fund holds more than 300 U.S. healthcare companies that span the industry. Want exposure to biotech, pharmaceuticals, healthcare distributors, life sciences services companies, health insurers, and more? This one fund has you covered. 

Like nearly all Vanguard products, this fund's expense ratio of just 0.10% is about as low as it gets. Income investors will also like that the ETF also throws off a dividend yield of 1.5%.

Turning to performance, the VHT has produced annualized returns of nearly 17% over the past decade. That's a return that thumps the S&P 500 in general.

The only knock that I can think of against this ETF is that it has limited transparency. This ETF's holdings are only released on a monthly schedule and are about two weeks old. However, that's a pretty minor negative in the grand scheme of things. What's more, the fund's turnover ratio is just 4.3%, so its holdings barely fluctuate from month to month anyway.

For investors who are looking for a one-and-done approach to healthcare, the Vanguard Health Care ETF is a rock-solid choice. 

2. The SPDR S&P Biotech ETF 

I'm a firm believer that advances in biotechnology will allow us all to live longer, healthier lives. At the same time, I'm painfully aware of just how difficult it can be to pick stocks in the space. The boom-or-bust nature of the business is a big reason why I think that adding biotechnology exposure through an ETFs make a lot of sense.

Investors that are interested in biotech have several great options to choose from, but my personal favorite is the SPDR S&P Biotech ETF. I like that this fund uses an equal weight approach to building the portfolio, which gives it a much higher exposure to small caps biotech stocks. The fund is also rebalanced quarterly, which limits investors' exposure to any individual company.

The fund holds more than 120 companies too, so it's incredibly well diversified. The bargain hunter in me also likes that its expense ratio of 0.35% is very reasonable.

Even with its conservative approach to biotech, this fund has been a stellar long-term performer. The fund has compounded at 18.6% over the last 10 years, which is a phenomenal result.  

3. iShares U.S. Medical Device ETF

Many investors overlook the medical device industry because they usually don't grow as quickly as biotechnology companies and their products are not used by consumers. That's a shame because medical devices companies are a fertile hunting ground for investors because healthcare providers tend to stay brand-loyal once they find a product that they like. I spent the first decade of my career selling medical devices, so I've seen first hand just how hard it can be to get a healthcare provider to change their behavior. I believe that these factors make the iShares U.S. Medical Device ETF an excellent place for healthcare investors to park their long-term capital.

This ETF owns a position in 59 different companies that manufacture and distribute a wide range of medical devices. The majority of the fund's assets are concentrated in the biggest medical device makers like Medtronic, Abbott Laboratories, and Thermo Fisher Scientific, but it also holds a number of smaller positions in some of my favorite fast-growing medical device companies such as Abiomed, Dexcom, and Penumbra.  

The IHI sports an expense ratio of 0.43%, which is higher than I'd like it to be, but not terrible in the grand scheme of things. The fund also throws off a dividend yield of 0.2%.

Turning to performance, the IHI has compounded investors' money at a 17.4% rate over the past decade. That's a wonderful return when considering that the majority of this ETF's assets are held in industry giants.

Overall, I think that the IHI is a great fund for healthcare investors to consider. 

Which healthcare ETF is best for you?

Every investor has their own set of needs that need to be carefully considered before they choose an ETF. Conservative investors that want to take a hands-off approach to the markets are probably best served by choosing an ETF with broad-based exposure such as the Vanguard Health Care ETF. Investors who do not mind volatility and want to swing for the fences are probably better off choosing an ETF that focuses on biotechnology.

What's wonderful about all of these ETFs is that they are all poised to prosper as the world's population continues to age and spending on healthcare continues to increase. With a tailwind like that in place, it's hard to go wrong with any of them.