How To Play Biotech With ETFs

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I have always loved biotech. I got my start in this industry as a biotech analyst for an actively managed mutual fund, and spent a number of fun years working at Genzyme, one of the largest biotech companies in the world.

For the past few years, however, watching biotech has been like watching paint dry. The broad-based iShares Nasdaq Biotech ETF (NYSEArca:IBB) is trading exactly flat over the past 10 years. That's astonishing, considering how the biotech industry has evolved. In 2001, the biotech industry was full of hopes and dreams; companies with no revenues but big opportunities. Today it's full of hugely profitable and fast-growing companies like Celgene, which expects revenue to grow from $3.6 billion to more than $5 billion over the next year.

Biotech also has badly lagged U.S. equities since the market bottom on March 9, 2009, with IBB rising "just" 62 percent against a rise of more than 100 percent for the S&P 500.


Yesterday, however, my former employer Genzyme inked a $20 billion buyout deal with Sanofi-Aventis, sparking renewed interest in the sector. Many analysts expect more pharma/biotech mergers in the future. Other eternal optimists (like me) expect biotech growth to surprise on the upside generally in the coming years, as early insights into genomics finally start turning into products.

There are five choices for ETFs in the biotech space, and they vary widely. Choosing the right one will have a big impact on overall returns.

How To Play Biotech With ETFs

Let's review.

Choice 1:iShares Nasdaq Biotech ETF (NYSEArca:IBB): IBB is the oldest and largest biotech ETFs. It was first-to-market, has the best liquidity and, with $1.3 billion under management, is by far the biggest.

IBB tracks a market-cap-weighted measure of the biotech sector, meaning it puts the bulk of its assets into the largest, most established biotech companies. For example, it has a 7.4 percent position in Amgen.

This is important because the biotech industry is bifurcated. There are a dozen or so large, well-established and hugely profitable biotech companies, like Amgen, Gilead, Genzyme and Celgene, that dominate market-cap-weighted indexes like the one IBB tracks. These companies are best thought of as biotech/pharma hybrids:They share some of the excitement of early-stage biotech start-ups, but also some of the challenges of the pharmaceutical industry, including slow-growing older products, the need to reinvigorate development pipelines, etc. The other half of the industry is composed of earlier-stage start-ups-generally smaller companies with more promise than profits.

IBB's focus on large-cap stocks should make it more stable than other funds. In addition, large companies like Genzyme are attractive acquisition candidates right now, as they are large enough to move the needle in terms of revenue and profit for major pharmaceutical companies.

If the bio/pharma merger parade really starts moving, IBB could be a good choice.

Choice 2:SPDR S&P Biotech ETF (NYSEArca:XBI): XBI is the second-most-popular biotech ETF, with $428 million in assets under management. XBI tracks an equal-weighted index of 30 biotech companies. That means it puts an equal amount of money into a $50 billion giant like Amgen ( AMGN ) as it does into an $800 million small-cap like Acorda Therapeutics ( ACOR ).

This has the effect of de-emphasizing the biopharmaceutical giants in favor of earlier-stage, riskier small-caps. That means added risk, and potentially added rewards, although less exposure to massive biotech buyouts like Genzyme.

Choice 3:First Trust NYSE Arca Biotechnology ETF (NYSEArca:FBT): FBT is a very interesting third option, and is quickly gaining ground on popularity compared to XBI.

Like XBI, it tracks an equal-weighted index of biotech companies. It's more concentrated than XBI, holding just 20 securities, and focuses heavily on drug development companies.

FBT has been by far the best-performing biotech ETF over any recent time frame you measure. The fund is up almost 90 percent over the past two years-nearly triple the return of IBB and over four times more than XBI's return. When you hold a focused portfolio of just 20 names and you get those names right, you do well.

I continue to like the looks of FBT's portfolio. It's a classic play on early-stage drug discovery, de-emphasizing the Amgens of the world in favor of potentially more interesting developing companies.

FBT has $217 million in assets.

Choice 4:PowerShares Dynamic Biotechnology & Genome Portfolio (NYSEArca:PBE): PBE is a relatively small fund with just shy of $200 million in assets under management. It tracks a quant-driven index that selects 30 biotech companies based on a variety of fundamental and technical measures, including valuations and momentum.

The portfolio has significant turnover, so there's not much use to actually studying its holdings. What it owns today is not what it will own next quarter. If you buy PBE, you're buying into its quant-based screening mechanism, which broadly speaking tilts toward  small-cap companies and in favor of tool providers rather than drug-discovery companies. The reason is simple:Tool providers are often more profitable and therefore do better on certain fundamental measures than drug-discovery firms.

Also, the quant algorithm behind the PowerShares Dynamic ETFs tends to do better in some markets than others. Biotech isn't one of its strengths-probably because some of the most interesting companies don't have either revenues or profits-and PBE's performance has suffered as a result.

Choice 5:Biotech HOLDRs ( BBH ): The fifth choice is the biotech holders, or BBH. Like most HOLDRS, BBH is not a well-structured fund. HOLDRs are unable to rebalance their portfolios, which were set up in the mid-1990s. This "frozen-in-time" element means that most HOLDRs have huge concentrations in certain stocks, as whatever companies did well in the late-1990s and early 2000s gained a dominant share of the portfolios.

That's decidedly the case here:Amgen is 33 percent of the fund, Gilead is 25 percent and Biogen Idec is 18 percent. This strong concentration can lead to strong performance-BBH popped nicely when Genzyme was acquired, as it had a 10 percent position in the name-but it's random and arbitrary. If you want exposure this concentrated, buy single stocks instead.

Conclusion

There are a number of good choices in biotech. If you want broad-based exposure that tilts toward large bio-pharmaceuticals, IBB is a good choice. If you want more pure-play exposure to earlier-stage drug-discovery firms, a fund like FBT or possibly XBI rises to the top. PBE offers exposure to biotech tool providers, although the performance is variable. And BBH … well, there's not much good to say about BBH.

Don't forget to check IndexUniverse.com's ETF Data section.

Copyright ® 2011 Index Publications LLC . All Rights Reserved.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , ETFs

Referenced Stocks: ACOR , AMGN , BBH , FBT , IBB

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