Smart Biotech Investing Means Picking the Right ETF

Since March, I’ve been recommending positions in the iShares Nasdaq Biotech ETF (IBB) as essential and efficient exposure to what could be the most explosive growth trend of the next decade. Biotech is essential because it is a way to “own the future” that is not economically dependent on a consumer-driven economy. ETFs are the efficient choice because, if well-constructed, they offer investors conservative participation in a sector-focused basket of leading companies and they allow you to easily trade the swings, which enhances returns, or change your mind, which enhances control.

By mid-September, the IBB advanced from below $60 to a 52-week high of $84 and I compiled a quick list of all the bio-pharma deals of 2009 driving this advance in my report “Biotech Bull Train Fueled by M&A”

I chose the IBB as the best instrument for conservative investors after rejecting a few others: the Biotech HOLDRs (BBH), the SPDR S&P Biotech ETF (XBI), and some of the newer, more-focused ETFs whose lack of liquidity or narrowness made them ineffective for my goal, which was simply safe and broad exposure to the industry that avoided both the necessity of expert stock-picking and the excessive volatility of biotech company-specific risks.

But today I came across one outstanding biotech ETF I had overlooked in a great “under the hood” article by Corey Williams of HyperionFinancial.com in their newsletter The Dynamic Wealth Report. Williams quickly breaks down the pro and cons of six funds—including the three just mentioned—in his piece titled “Three Bogus Biotech ETFs… And One Great One.”

An ETF-focused advisor, Williams highlights some of the key criteria for evaluating any ETF: costs, diversification, liquidity, and index construction, which covers elements like security weighting and re-balancing methods. Based on his criteria, he also rejects BBH and XBI and two of the new comers. He likes IBB, but his favorite pick is the First Trust Amex Biotechnology Index Fund (FBT). His simple compare-contrast analysis of XBI vs. IBB vs. FBT is a great lesson in due diligence evaluation of ETFs.

Index Construction is the Key

IBB holds over 120 Nasdaq biotech stocks across all market caps, giving investors exposure to top names like Amgen (AMGN), Gilead (GILD), Teva (TEVA), Celgene (CELG), Genzyme (GENZ), Vertex (VRTX), and Biogen Idec (BIIB) as well as dozens of smaller, up-and-coming biotech names. It’s the small companies that get us excited in biotech investing because these are the places that new blockbuster drug discoveries can come from and turn a $2 stock into $20 ten-bagger.

But these “lottery ticket” stocks are far and few between and you can buy 10 of the wrong ones before you hit the jackpot, to say nothing of the stock that doubles or triples in price on news of FDA trials that eventually never pan out and the stock goes right back down—often in one day on the announcement. That’s why unless you do all the homework on these companies—and understanding biotech research has to be the hardest investing task out there—I think most investors will do better focusing most of their capital for this sector in a well-diversified ETF.

The problem with the IBB is that it is market-cap weighted, which means it will tend to concentrate assets in the big cap names and be underweight the small cap names which we just established have the most potential. While Corey Williams believes the IBB’s wide diversification makes it “quite possibly the best gauge of the biotech sector’s overall health,” he says its big cap bias “will keep [it] from fully capturing the explosive potential of biotech investing.”

XBI holds only 28 stocks and trades less than 125,000 shares per day on average. It has many of the same top-ten holdings as IBB and it is an equal-weighted index, meaning each issue is balanced to be roughly the same dollar slice of the fund pie. This gives small cap stocks more bang in determining the fund’s overall performance. But, with so few names, not many are of the small cap variety that has served the IBB so well this year, trouncing the XBI’s gains 15% to 1% respectively.

The Winner By a Genome

The IBB is certainly worth putting some long-term investment money into but as Williams says, “The secret is investing the same amount in the ‘Big Guys’ as the small start-ups.  That way you get steady growth and explosive upside potential.” His favorite equal-weighted biotech ETF, and the best performer in the sector for 2009, is FBT which is up over 50% for the year.  He believes that this ETF’s fair hand for the little biotech engines that could “gives FBT an edge over other biotech ETFs year in and year out.”

That might be true in the long run. But if we look at the specific stock action that actually gave this biotech ETF its outperformance over others in the same sector, we find a single culprit in 2009: Human Genome Sciences (HGSI). I only discovered this when I looked at a price chart and saw the massive price launch FBT had in July from $21 to $27 in two weeks! Sector ETFs don’t move 28% in two weeks, I thought, so I looked at the top holdings and sure enough, HGSI had grown to 21% by the end of September.

HGSI may have started out “equal-weight” in July when the stock was only trading for $5. But when it launched to $20 in late August, it gave the FBT its sector-beating performance. It appears that FBT has since rebalanced sometime in October, since HGSI is now back down to about a 5.5% weighting along with the other holdings, even as the stock has soared another 50% since then on confidence in its likely buyout by a bigger biopharma brother (probably Glaxo).

My conclusion? There’s a place for both the IBB and FBT in a biotech investment campaign. More importantly, this has been another great lesson in learning what’s “under the hood” of those handy, multiplying-like-rabbits power tools we call ETFs.

From the First Trust fact sheet for FBT:

Fund Objective

This exchange-traded fund seeks investment results that correspond generally to the price and yield (before the fund’s fees and expenses) of the NYSE Arca Biotechnology IndexSM. The NYSE Arca Biotechnology IndexSM is an equal dollar weighted index designed to measure the performance of a cross section of companies in the biotechnology industry that are primarily involved in the use of biological processes to develop products or provide services. Such processes include, but are not limited to, recombinant DNA technology, molecular biology, genetic engineering, monoclonal antibody-based technology, lipid/liposome technology, and genomics. The index is rebalanced quarterly based on closing prices on the third Friday in January, April, July & October to ensure that each component stock continues to represent approximately equal weight in the index.