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  • Guide to Biotech Investing (Published in 2004)

     

    Introduction: Balancing Portfolios With Biotech

    Rod Raynovich

    5/27/2011  

    Recent breakthroughs with new drugs and devices have eclipsed many of the concerns of healthcare reform. In addition, the pace of innovation is accelerating. These factors are making the sector especially attractive, acting as catalysts to draw even more capital.Investors have long been attracted by the innovation and potentially large returns in the life sciences and biotechnology sector. In the past five years, biotech has emerged as one of the best performing technology sectors, according to numerous indices and funds. And now there’s evidence biotech has the potential to become even more important.

    There are good reasons to consider biotech investments. By investing in biotech, investors gain general technology exposure and also balance some of its volatility. Consider the performance of a popular exchange-traded fund, the PowerShares QQQ Trust, Series 1 (Nasdaq: QQQ). QQQ, based on the Nasdaq-100 Index, returned 38% in the past five years, slightly better than the 35% returned by the Nasdaq Biotechnology Index. In contrast, the S&P 500 was up only 1% because of the recession and financial crisis of 2008.

    As the chart below shows, biotech, as measured by the Amex Biotech Index, has had a nice run.

     

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    One big advantage of the biotech sector is its relative immunity to economic downturns. In fact, biotech came out quite well during the 2008 financial crisis. It had a shallower pullback and outperformed the S&P 500 during the recovery. Many biotech and drug endeavors are long-term investments. In addition, healthcare growth continues to outpace the overall economy because of industry and demographic factors.

    Despite the strength of the sector, many investors have shied away over concerns about unreliable earnings and the seemingly endless need for cash to fund research and development. But investors can’t analyze small- and mid-cap life science stocks solely on fundamentals, because there are many other drivers, including the value of intellectual property and the food chain effect of mergers and acquisitions.

    For the individual investor, stock-picking in biotech is undeniably time consuming. Is your knowledge of molecular biology up to date? Are you familiar with targeted therapies utilizing humanized monoclonal antibodies? What is autologous therapy? What does RNAi do? Are therapeutic stem cells commercialized? What is personalized medicine? It’s no wonder investors can feel overwhelmed.

    Not many people are willing to follow the latest medical news and/or take the time to understand the scientific basis for novel therapies in biotechnology, especially analysis of clinical data and the implications of FDA regulations. But there are nonetheless options in biotech, including mutual funds and ETFs.

    Just recently, Investor Uprising published a review of underlying trends in the biotechnology market. (See: The Biggest Biotech Trends.) Many trends, including new drug development and innovation, along with merger and acquisition activity, are likely to spur growth in the sector for years to come.

    To cover biotech with appropriate diversification, investors should target at least 10 positions, including ETFs. The good news? Biotech ETFs are rather strong overall, and, unlike some of the arcane and complicated ETFs in commodities, real estate, and other sectors, investors’ positions are easier to understand and track.

    So how do you play the whole biotech sector, without taking excess risks? We’ll explain everything you need to know in this guide, which details several important funds and ETFs that offer exposure to the biotech sector.

    Contents:

     

     

    Next Page: The Top Biotech Funds

    Guide to Biotech Investing

    The Top Biotech Funds

     

    Rod Raynovich

    5/27/2011

    T.Rowe Price Health Sciences Fund (PRHSX)Recent mutual funds data shows investments in biotech and life sciences are up 13% through April. Here are some of the leading funds in the sector YTD (data as of May 6, 2011):

    The chart below shows the performance of these funds, and how the correction was shallower than it was for the general indices during 2008.

     

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    But these aren’t the only funds to consider. Pharmaceuticals, for example, have also heated up, as the Fidelity Select Pharmaceuticals Fund (FPHAX) demonstrates. It’s increased 15% YTD, earning it a 4-star Morningstar rating.

    Large-cap drug stocks, left for dead during the 2009/2010 rally, are also catching renewed attention. These stocks are benefiting from the life science rally because dividend investors favor them; they tend to be value plays with strong underlying financials; and they have the core technology to create product pipeline.

    Comparing mutual funds to ETFs can be more difficult because of loads, fees, and taxable distributions. Healthcare funds weighted toward large-cap stocks and lower risk may not be positioned in emerging biotechnologies or in mid-to-small cap growth stocks. The table below summarizes these top funds, which I believe are among the best in the industry for these sectors:

    Top Biotech Mutual Funds
    Symbol Price Value $B 1 Yr. Return 5 Yr. Return 5 Yr. (annualized)
    PRHSX 35.60 2.8 37.72% 40.6% 10.4%
    FBIOX 84.58 1.23 29.75% 35.75% 6%
    SHSAX 31.95 1.43 17% 29.8% 9.56%

    Next Page: The Top Biotech ETFs

    The overall ETF biotech sector is very strong. The major health and biotech funds within it have tracked performance of the biotech mutual funds, with gains of 15% to 20% YTD. ETFs and funds that are over-weighted in larger cap, blue-chip drug funds, such as Health Care Select Sector SPDR XLV and Vanguard Health Care ETF VHT, may offer more defensive positions in a down market because of the quality of earnings.

    However, in the past five years, this has not been the case. Here are three of the most liquid biotech ETFs, compared to the PowerShares QQQ Trust Series 1, which includes all of the stocks of the tech-heavy Nasdaq 100 Index:

    Most Liquid ETFs Vs. QQQ
    Symbol Price 5/6/11 Net Assets ($B) 52-week Range 1 yr. Return 5 yr. Return XTF.com Rating*
    FBT 44.26 0.218 29.40-45.50 39.5 122 5.1
    IBB 106.49 1.63 74.50-109.61 28.9 36.5 7.1
    XBI 72.29 0.471 47-75.17 35 51 6.4
    QQQ 58.47 49.1 41.77-59.3 28.75 38.7 8.6
    * 10 is best

    Let’s summarize these ETFs.

    First Trust NYSE Arca Biotech Index (NYSE: FBT)
    Fund Inception: 6/19/06

     

    This ETF closely tracks the NYSE Arca Biotechnology Index, an equal-dollar weighted index that measures the performance of a cross-section of companies. The NYSE Arca Biotechnology Index has outperformed the S&P 500 in the past five years by about 117%, and in the past year by 13%. It is rebalanced quarterly on the third Friday of the month.

    About 20 stocks are included in the fund, with about 5% weighting of ten mid-large cap ($5 billion to $50 billion) stocks, such as Biogen Idec Inc. (Nasdaq: BIIB), Celgene Corp. (Nasdaq: CELG), Life Technologies (NYSE: LIFE), Regeneron Pharmaceuticals Inc. (Nasdaq: REGN), and Vertex Pharmaceuticals Inc. (NYSE: VRTX). The beta for the fund is 0.89, slightly more volatile than the S&P 1500 healthcare index of 0.69. The fund is relatively small, with concentrated positions in the leading companies with few small-cap speculative positions. Use of options and short-selling is permitted. Expense ratio is 0.66%.

     

    iShares Nasdaq Biotechnology Index (Nasdaq: IBB)

    Fund Inception: 2/5/01

     

    iShares Nasdaq Biotechnology Index, managed by Blackrock Institutional Trust Co., seeks investment results that correspond generally to the price and yield performance of companies represented in the Nasdaq Biotechnology Index.

    The IBB has outperformed the S&P 500 by about 34% since mid-2008 and by 4% in the past year. The sector breakdown is 66.74% biotechnology and 33.50% pharmaceuticals. Large-cap biotech stocks are among the top seven holdings totaling 33.7%, with representation of the major players: Amgen, Celgene, Gilead (Nasdaq: GILD), and Teva Pharmaceuticals (Nasdaq: TEVA). Teva is acquiring Cephalon (CEPH), the privately-held Taiyo Pharmaceutical Industry Co., and others.

    The top 20 positions are about 67% of the portfolio. The IBB differs from other ETFs because it has many mid- and smaller-cap companies beyond its top 20 positions, which makes it highly diversified yet still concentrated in the well capitalized names with growth in revenue and earnings. As an example, the fund may own as many as 125 stocks at any given time, but 100 may have less than a 1% holding. Some of this diversification includes small cap companies that are:

    • More speculative because they are in the discovery or clinical development stage, or engaged in biomedical research.
    • Focused on tools and diagnostics, including mid- and small-cap growth.
    • Innovative technology platforms that have valuable intellectual property with multiple product applications.

    Depending on the analytics used and the frequency of rebalancing, the IBB may be able to spot big winners on its radar screen and weight appropriately. In the current life science bull market, this can provide an advantage because speculative stocks with good clinical news or major deals on the horizon can appreciate quickly.

    As a case in point, Human Genome Sciences Inc. (Nasdaq: HGSI) soared from $2.50 to $27.75 in 24 months, and Exelixis Inc. (Nasdaq: EXEL) is up 300% to $11 in one year. Amazingly, the beta is the same as the S&P 500 Index, and hedging with options and futures can be used. The turnover rate for the portfolio is 11%. The expense ratio is 0.48%.

     

    SPDR S&P Biotech ETF (NYSE: XBI)

    Fund Inception: 1/31/2006

     

    The S&P Biotechnology Select Industry Index represents the biotechnology sub-industry portion of the S&P Total Markets Index. It tracks all the US common stocks in all exchanges on an equal weighted market cap basis. The XBI has outperformed the S&P 500 Index by about 49% since May 2006 and by about 6% in the past year.

    The five-year performance at the end of the last quarter is 6.19%. The fund has a low turnover of 74 days, with about 48 holdings concentrated in the large-cap names with an average market cap of $6.4 billion. The top 10 holdings comprise about 29% of the portfolio with the usual well known companies: Amgen, Biogen, Celgene, Gilead, and Vertex. Two of the top 10 stocks have made big moves and are at an earlier stage of development. The expense ratio is 0.35%.

    The chart below summarizes the performances of these three major biotech ETFs:

     

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    There are other ETFs in the biotechnology sector, but the ones we’ve discussed here, including Vanguard’s VHT for large-cap general healthcare, offer sufficient diversity for most portfolios. Another example is Biotech HOLDRS (NYSE: ARCA:BBH), which has a very high rating of 7.7 from Xtf.com. But the fund is highly concentrated, with 85% in three large-cap biotechs. The portfolio is not managed and does not track a specific index, so expense fees are very low. The fund has underperformed other ETFs, although it did have a big winner when Genzyme Corp. was acquired by Sanofi-Aventis (NYSE: SNY).

    Next Page: Conclusion: Biotech – A Must for Diversity

    The funds and biotechnology or life science ETFs that are covered in this report track the sector well. They are good investment vehicles to allocate in a wider-ranging healthcare investment portfolio. Although past performance is never a guarantee of future results, it’s worth noting that the biotech sector has outperformed the S&P 500 over the past five years, despite weakness in the healthcare and large-cap drug sectors.

    In the past five years, the relative performance of ETFs saw First Trust Amex Biotech Index (FBT) in first place, with a 122% cumulative return, followed by SPDR S&P Biotech (XBI) with a 51% return, and the iShares Nasdaq Biotechnology (IBB) a close third with 38.7%. The variation in performance may be the result of better stock picking, more concentrated positions, or better software and forecasting technology.

    In general, biotech and life science stocks have outperformed the S&P because they represent a growth market that was less affected by the 2008 economic downturn. Growth was spurred by scientific breakthroughs (such as genomics and targeted therapies) and merger activity, as larger companies with strong balance sheets capitalized on gaining access to new pipelines of products and technology. In other words, the biotech sector is less correlated with cyclical stocks, and sometimes less correlated with even economically sensitive technology stocks. The sector moves in a world of its own.

    That’s not to say biotech stocks can’t be volatile, because they can. Individual considerations, such as the approval (or lack of it) from the US Food and Drug Administration (FDA), can result in large daily moves. Given the potential volatility in the sector, investors in biotechnology should seek a diversified portfolio to buffer the volatility of individual stocks.

    We’ve suggested some of the best biotech mutual funds and ETFs to add to portfolios for diversification and comparison. So why invest in biotech? In summary:

    • Because biotech can have a growth bent but doesn’t always correlate with the macro economy, the sector can provide an interesting way to gain general technology exposure.
    • Life science ETFs track the PowerShares QQQ ETF (which holds all of the securities of the Nasdaq 100 Index) and complement the volatility of the tech sector. In the past five years, the QQQ returned 38%, while the iShares Nasdaq Biotechnology (IBB) returned 35%. In contrast, the S&P was up only 1%.
    • Biotechnology or life science ETFs track the sector well and are good investment vehicles to add to a wider-ranging healthcare investment portfolio. Although, again, past performance is never a guarantee of future results, the sector has done well the past five years, in spite of the recession.
    • Biotech and life science stocks have outperformed the S&P because of scientific breakthroughs, mergers and acquisitions, and FDA approval of new therapeutic categories, especially cancer.

     

    Biotech is generally less sensitive to the economy than other sectors, and ETFs bring diversification and comparison to portfolios. Given the potential for solid long-term returns and the opportunity to counter-balance more economically sensitive stocks, individuals should give strong consideration to adding biotechnology exposure to their investment portfolios.

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