The five biotech ETFs have very different portfolios with markedly different performance.
For exchange-traded fund investors, there is virtually no other place in the equity markets where the benefits of diversification are more apparent than in the notoriously volatile biotechnology sector of health care.
One drug's odds of success typically have no bearing on another drug's likelihood of succeeding, and investors can think of an ETF as a portfolio of bimodal options. Many publicly traded biotechs are early-stage players with no drug on the market yet. A small subset of those firms will develop therapies that prove safe and effective and eventually come to market, often resulting in explosive success for those firms and instant economic moats, or competitive advantages. The vast majority of biotech companies, however, will fail to meet clinical hurdles for their drugs in development and fall by the wayside.
Right now, plenty of investor attention is focused on the biotech space for a different reason: potential merger-and-acquisition activity. It's widely believed that large pharmaceutical firms will continue to be major acquirers of biotech firms in the coming months, as Big Pharma sees massive upcoming patent losses and relatively poor research and development productivity (and little further opportunity to consolidate among one another). So, Big Pharma has been looking at absorbing large and small biotech firms alike. Already, we have seen Roche
From a fundamental perspective, in 2010, large-cap biotechs suffered from some pricing pressure (owing to U.S. health-care reform and European austerity measures), and an industry tax should erode earnings by 1% to 2% in 2011. Looking ahead, we see something of a "return to normal" for the entire biotech industry in the very near future. Morningstar equity analysts see stabilization next year, after a tough 2010 and the annualization of some measures in 2011.
Even so, the entire biotech space has done extremely well, relative to the broader market. For ETF investors, the biotech industry has been the place to be for capital appreciation in recent years, with all biotech ETFs significantly outperforming the S&P 500 over the last five years.
We think there is plenty of rapid growth ahead in the biotech sector. There are several drugs for diseases with high unmet patient need and favorable demographic trends that are approaching the market, including for diabetes, hepatitis C, and cancer.
Currently, investors can choose from among five biotech ETFs. There are meaningful differences in portfolio construction and performance among the five, and we would suggest that investors study the funds closely before investing. Below we highlight the five funds and then make our recommendation.
IShares Nasdaq Biotechnology
Far and away the biggest and most liquid of the biotech ETFs, IBB holds more than 125 biotech firms listed on the Nasdaq with market caps of at least $200 million. It follows a cap-weighted index, meaning that close to half of its assets are invested in its top-10 holdings. Morningstar analysts believe this ETF is close to fully valued, trading at 99% of its fair value. The fund charges a 0.48% expense ratio. This is the second best-performing biotech ETF over the last five years (rising an impressive 44%). The fund also has posted generally smoother recent performance than some of its biotech peers.