Biotech ETFs have had a banner year, earning some investors
returns north of 30 percent since January. I say "some investors"
because, it turns out, not all biotech ETFs are created equal.
In our 2012 first-half performance charts, biotech ETFs make up
three of the top-four-performing funds. That's out of
ETFs on the U.S. market, an impressive performance.
But looking more closely at their general success, some of those
biotech ETFs returned far more to their investors than others.
If you invested in the top-performing fund on Jan. 1, you would
have earned a 37 percent return on your money. If you
invested in the worst-performing fund, you'd have earned just 14
A lot of times, particularly in the hyperventilating tone so
common in financial journalism, the focus of ETF articles is on the
hottest trend:a niche market of bonds, the latest industry to
invest in, etc. The actual ETFs, and their inner workings,
are almost an afterthought.
That is at odds with the fact that the largest determining
factor in the returns of an ETF is the index it tracks. Hence the
23 percentage points in return you'd have missed by choosing the
wrong biotech ETF this year.
In this case, we can do a midyear review of the ETFs in
question, and look at how they differed and get a sense of what
drove their returns.
To set the stage, five ETFs offer biotech exposure; one offers
global exposure while the other four invest in U.S. firms
Of the U.S.-focused ETFs, the index strategies differ.
The iShares Nasdaq Biotechnology ETF (NYSE Arca:IBB) is the only
fund to use a straight-ahead market-capitalization approach to
weighting its holdings. It's also the most broadly diversified,
spreading its assets among more than 100 biotech firms. Its quirks
lie in its selection methodology:the ETF will only hold stocks
listed on the Nasdaq exchange.
That doesn't turn out to hugely affect its holding though-most
biotech firms list on Nasdaq anyway. In other words, the fund is,
for the most part, a well-diversified take on the whole U.S.
The First Trust NYSE Arca Biotechnology ETF (NYSEArca:FBT)
eschews market-cap weighting in favor of equally weighting its
constituents, and it has done significantly better than IBB this
The equal weighting assigns more assets to the smallest players
in the market than does a fund like IBB, so it reaps outsize
benefits from the growth of the little guys, which can be
For example, FBT gives identical exposure to the biotech
powerhouse Amgen as it does to the lesser-known Sequenom Inc., and
all told, it devotes nearly a third of its portfolio to small-cap
BBH, the Market Vectors Biotech ETF (NYSEArca:BBH), is
ostensibly a global ETF, but in practice, holds almost entirely
U.S.-based firms. The fund is also the only market-cap-weighted and
market-cap-selected biotech ETF. What that means is that the fund
holds firms according to their value in the market-firms with
higher valuations make up a larger part of the portfolio.
It also means the fund plays the role of a sort of market
benchmark, mirroring the holdings of the market at large, though it
is limited to just 25 holdings. BBH has earned the third-best
returns of the biotech ETFs this year.
The PowerShares Dynamic Biotech and Genome Portfolio ETF
(NYSEArca:PBE) has been the laggard of the bunch. It has a very
different take on the market than the other ETFs, using a
quantitative strategy to select and weight its holdings.
Its consideration of factors like price momentum in selecting
biotech firms has only hurt investors so far this year. That
said, the fund places heavy bets on the smaller end of the
scale-the ETF is more than 40 percent in small-caps.
Lastly, the best-performing fund in the segment was the SPDR
S&P Biotech ETF (NYSE Arca:XBI), another equal-weighted fund.
Just as FBT does, XBI allocates heavily to small-caps; in this
case, even more so. The fund has 40 percent of its holdings in
smaller names, giving it a pretty big tilt away from the market as
There aren't any easy conclusions to draw here about optimal
portfolio construction, but it's clear that the index an ETF tracks
can really affect returns.
The top-performing biotech funds this year were equal weighted,
suggesting small-cap stocks may have determined their success. The
performance of PBE, which allocates heavily to small-caps, stands
in the way of that theory-again, it had the worst returns of the
It's also worth noting that equal-weighted funds haven't always
done so well. If you extend the holding period to 12 months,
market-cap funds have significantly outperformed the equal-weighted
funds that have done so well this year.
It the same message every time:Know what you're getting into and
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