Get Instant Biotech Diversification

Biotechnology is a notoriously volatile industry. Shares of individual firms often skyrocket or plummet based on clinical test results. Because biotechs tend to march to the beat of their own drum--share prices are much more sensitive to clinical trial results and merger activity within the sector than they are to the economic backdrop�they can be an interesting small addition to a satellite portfolio.

We think investing in the industry via an ETF makes a ton of sense. With a single transaction, investors can achieve instant diversification and mitigate the risk of being too exposed to any one firm.  PowerShares Dynamic Biotech & Genome (PBE) might fit the bill for investors seeking to easily add some biotechnology exposure to their portfolios.

This exchange-traded fund tracks a dynamic index consisting of 30 biotech stocks. The index is governed by a quantitative model that aims to surpass the returns of traditional indexes by investing in stocks that display favorable fundamental growth, attractive valuation, and momentum traits. Investors should note that the weighting methodology applied here translates into higher exposure to firms with small market capitalizations. In fact, large-, mid-, and small-cap stocks make up roughly 13%, 43%, and 44% of total assets, respectively. Still, this ETF provides exposure to firms ranging all across the product-development spectrum, from those that boast blockbuster drugs--like  Amgen (AMGN) and  Genzyme --to others that lack a single approved drug--such as Immunogen .

The chances of a biotech getting a blockbuster drug through clinical trials and onto the market have been likened to those of going to Hollywood and becoming a star. Industry experts estimate that one in five therapies, at most, will survive the 10- to 15-year development and clinical gauntlet required to get regulatory approval. With the process costing $1 billion, on average, many biotechs surrender their drugs' marketing rights to big drug firms in exchange for cash upon reaching various development milestones. Thus, biotech firms lacking an approved drug have highly irregular cash flows.

Of course, with that risk and volatility comes great opportunity. Firms that develop innovative therapies and successfully get their products to market stand to reap bountiful rewards. Merger activity has also heated up in the industry, providing another potential catalyst. The headliner of the bunch, of course, was  Roche's (RHHBY) acquisition of Genentech. With a blitz of generic competition on the horizon, many are speculating that big pharma, with its cash war chests, may be on the prowl.

Health-care reform proposals have raised concerns among investors regarding the potential for government involvement. However, given that most biotechs tend to focus on biologics that address serious, chronic, or life-threatening illnesses, the challenges they might face as part of any major U.S. health-care overhaul differ slightly from those of large pharma. Both government and private insurers reimburse several highly profitable infused drugs approved to treat ailments such as cancer, multiple sclerosis, and rare genetic diseases as medical benefits, and these therapies have not seen the same negative pressure on volume and pricing that many oral or self-administered drugs have witnessed. In general, we think biologics are also less likely to see pressure on sales from future cost-containment efforts; many such therapies offer unique benefits to small subsets of patients, reducing the leverage that pharmacy-benefit managers have over drug firms in price negotiations.

In our view, the biotech industry is less susceptible to government intervention than are other health-care subsectors--like hospital operators or MCOs, for instance. In any case, we think an ETF is the appropriate tool for investing in this notoriously volatile subsector. To be sure, one drug's odds of success are typically unrelated to another's; we like the diversification among individual firms that this fund offers, which helps diffuse single-stock risk.

While we like the instant diversification this ETF provides, we're still cognizant of the fact that well over one third of the fund's holdings are early-stage players with no drug on the market yet. Would-be investors should note that because of the index's unique weighting scheme, these smaller firms, with decidedly uncertain prospects--and explosive upside potential--loom larger. Indeed, roughly 40% of the ETF's holdings have yet to turn a profit. The results of bi-modal businesses like upstart biotech firms--which are plentiful here--are very difficult to forecast, subjecting our fair value estimates to significant uncertainty. Thus, we'd demand a wide margin of safety before investing here.

 

Portfolio Construction
This quantitative-active ETF tracks an unorthodox benchmark called "the Biotechnology & Genome Intellidex"--an index operated by the AMEX that is designed to select and rank biotech stocks based on capital appreciation potential using a 25-factor proprietary AMEX Biotechnology & Genome Intellidex model. The 30-stock index selects banking stocks from the 2,000 largest U.S. stocks, in terms of market cap, that trade on the NYSE, AMEX, and Nasdaq. The selected stocks are divided into two subgroups determined by size. A defined number of stocks are then split into quintiles based on their market cap, where they are ranked by their Intellidex model scores. Larger stocks are defined by inclusion in the top quintile and smaller are the bottom four quintiles.

As this is a quantitative-active fund that tracks a dynamic Intellidex benchmark, investors should expect significantly higher portfolio turnover relative to traditional ETFs that track traditional broad market indexes. However, this shouldn't deter investors, because the unique "in-kind" creation and redemption process for ETFs helps ensure maximum tax efficiency. Because of the dynamic nature of the ETF, investors may wish to scan the portfolio holdings on a quarterly basis to ensure that the portfolio continues to meet their investment objectives or expectations.

Eight of the top-ranked relatively larger stocks are selected and collectively receive 40% of the total index's weighting (which translates to a weighting of roughly 5% for each stock). Finally, 22 of the top-ranked relatively smaller stocks are selected and collectively receive 60% of the total index's weight; each of the smaller stocks makes up 2.73% of the index, on average. The methodology evaluates companies quarterly, based on a variety of criteria, including fundamental growth (7 factors, 29% weight), stock valuation (7 factors, 28% weight), investment timeliness (6 factors, 28% weight), and risk (5 factors, 15% weight). The fund's equal-weighting methodology, along with quarterly rebalancing, ensures that no single stock will ever dominate the index.

We'd also note that the ETF's screening and weighting methodology leads to a portfolio that's biased toward small- and mid-cap stocks. For instance, PBE's average holdings-weighted market cap at the end of August 2009 was less than $2.2 billion, compared with approximately $2.9 billion for the equal-weighted  SPDR S&P Biotech (XBI) and roughly $5.9 billion for the cap-weighted  iShares Nasdaq Biotechnology (IBB).

Fees
The ETF's 0.60% expense ratio, while low in absolute terms and versus the typical health-care mutual fund, exceeds that of rival ETFs that track purely passive benchmarks. Whereas most ETFs track static indexes that require minimal intellectual input and maintenance, this fund rebalances regularly based on cumulative scores from its proprietary Biotechnology & Genome Intellidex model.

Alternatives
Investors seeking exposure solely to biotechs have other ETF options:  SPDR S&P Biotech (XBI) (0.35% expense ratio),  iShares Nasdaq Biotechnology (IBB) (0.48% expense ratio), and  Biotech HOLDRs . Those looking for similar exposure to small-cap stocks might take a closer look at XBI, which equally weights its portfolio of about 30 stocks. On the other hand, IBB tracks a cap-weighted index containing roughly 120 biotech stocks. BBH is an extremely concentrated portfolio of just 13 stocks, with its top three holdings consuming more than 80% of assets. Investors looking for as much diversification as possible might side with IBB because of its large number of holdings. On the other hand, those looking for high beta exposure to the group by moving down the market-cap ladder might consider PBE or XBI to be more favorable alternatives.

 

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Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), Claymore Securities, First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.