As the ETF industry has grown by leaps and bounds in recent years, continued innovation has enabled investors to achieve more granular exposure than ever through exchange-traded products. Diversified ETFs targeting relatively narrow sectors of the domestic and global economy have multiplied, including funds targeting the airline, gaming, insurance, gold mining, timber, and food and beverage industries.
But the expansion of the ETF industry has also presented investors with more and more options for achieving their desired exposure within a particular asset class of industry. The large cap blend equities ETFdb Category contains almost 30 ETFs, while there are more than a dozen funds targeting emerging markets.
Even within relatively targeted biotechnology industry, there are a handful of ETFs available, including products from iShares, State Street, PowerShares, and First Trust. Some covering the ETF industry point to the presence of five biotech funds as a clear indication of over-saturation in the industry. But while these funds are similar in many ways–including significant overlap in holdings in some cases–they are far from identical.
Biotechnology ETFs can be impacted by a wide variety of factors, including:
- New Product Pipeline: Biotech companies often invest heavily in research and development of products that ultimately prove to be unsuccessful commercially or that never make it to market. As such, the industry relies on a few “home run” products to drive significant revenue and earnings. In July 2009, for example, Human Genome Sciences surged more than 450% in a week after its lupus drug Benlysta showed late-stage success in a clinical trial.
- Regulatory Environment: The biotech sector is heavily dependent on protection of patents and intellectural property rights. To the extent that new regulation altering existing patent laws in passed, the outlook for the industry could change change dramatically.
- Takeover Activity: The biotechnology space has historically been a hotbed or merger and acquisition activity, as larger firms have sought to snap up smaller companies with promising but unproven product pipelines. Last year, biotech ETFs got a big boost when Bristol-Myers Squibb Co. announced plans to acquire antibody technology specialist Medarex at a premium of close to 90%.
Biotech ETF Options
Because the success of biotech firms often depends on unproven revenue streams, companies in this industry can be extremely risky. As such, many investors have prefer to gain diversified exposure to the sector through ETFs that maintain well-diversified holdings. Currently, there are five primary options for U.S. investors looking to achieve exposure to biotechnology companies.
Below, we profile these five biotech ETFs, highlighting potential strengths and weaknesses of each.
This fund is linked to the S&P Biotechnology Select Industry Index, a benchmark that represents the biotechnology sub-industry portion of the U.S. market. XBI includes biotech stocks traded on the NYSE, AMEX, and NASDAQ exchanges.
Pros: Because the index underlying XBI is an equal-weighted benchmark, XBI avoids excessive exposure to any one biotech company (as evidenced by the lowest aggregate allocation given to the top ten holdings). XBI is also the cheapest biotech ETF option, charging an expense ratio of just 0.35%.
Cons: With 28 component companies, XBI offers less depth of exposure than the PowerShares and iShares biotech ETFs.
PowerShares Dynamic Biotechnology & Genome Portfolio (NYSEARCA:PBE)
This ETF is based on the Dynamic Biotechnology & Genome Intellidex Index, an “intelligent” benchmark that seeks to identify stocks poised for outperformance. The Intellidex methodology analyzes potential index constituents on a variety of investment merit criteria, including fundamental growth, stock valuation, investment timeliness and risk factors.
Pros: This ETF is based on a modified equal-weighted index, meaning that the largest companies don’t necessarily receive the biggest weightings. PBE has also delivered strong performance over the last year, adding more than 15% during that period.
Cons: PBE’s expense ratio is at the high end of the range for biotech ETFs, 25 basis points above XBI.
This ETF is linked to the NASDAQ Biotechnology Index, a benchmark that includes biotechnology and pharmaceutical companies listed on the NASDAQ exchange.
Pros: This ETF offers by far the most depth of exposure, investing in more than 125 individual stocks. With average daily volume of about 700,000 shares, IBB is also the most liquid of the group.
Cons: Despite its broad base, IBB is relatively top-heavy: the top ten components account for almost half of total holdings while 60 companies have an allocation of 0.25% or less.
First Trust NYSE Arca Biotechnology Index Fund (NYSEARCA:FBT)
This ETF seeks to replicate the performance of the NYSE Arca Biotechnology Index, an equal dollar weighted benchmark composed of companies primarily involved in the use of biological processes to develop products or provide services. Such processes include recombinant DNA technology, molecular biology, genetic engineering, monoclonal antibody-based technology, lipid/liposome technology, and genomics.
Pros: This ETF has outperformed the other biotech ETFs by a wide margin over the last year, adding about 35% during this period.
Cons: The expense ratio of 0.60% is higher than both IBB and XBI. Although FBT has the lowest average daily volume of the group, the liquidity shouldn’t be a concern for most traders.
Biotech HOLDRS (NYSEARCA:BBH)
Like most other HOLDRS products, BBH concentrates its assets in a handful of individual stocks. At present Amgen, Gilead Sciences, and Biogen account for more than 80% of holdings, with the remainder of assets spread across fewer than ten stocks.
Pros: For investors looking to make a bet on some of the bigger names in the biotech industry, BBH may be the way to go.
Cons: For investors seeking diversified exposure to biotech companies, BBH may be too concentrated, and the price of this ETF may be impacted significantly by movements in its major component stocks.
As shown by the wildly-diverging performances of these funds over the last year, biotechnology ETFs are far from identical products, and no one fund will be right for every investor. Because each ETF tracks a unique index, these funds have unique risk and return characteristics (see our Index Database for a way to browse through all the benchmarks available through ETFs).
Those looking to minimize costs will likely zero in on XBI, while those looking to diversify across the most individual components will be attracted to XBI. Investors who believe in the benefits of quantitative analysis may like PowerShares PBE, while those considering recent historical performance will likely be impressed by FBT.
Disclosure: No positions at time of writing.