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As the 78 million baby boomers reach retirement age, they will place increased demand on the healthcare system. The general consensus is that the aging population will bode well for the healthcare stocks, since a majority of medical costs occur after a person retires. In particular, retired boomers are purchasing prescription drugs to treat the myriad of health problems that are related to old age. This is one of the reasons that the performance of the drug sector has been red-hot.

As a retiree myself, I appreciate the drug innovations that are increasing longevity. However, I also wanted to benefit financially by investing in the companies responsible for these advances. I am not a medical doctor, so it is difficult to analyze individual products. Therefore, I gravitated to Exchange Traded Funds (ETFs) and Closed End Funds (CEFs) that provide broad exposure to this sector. The main question I wanted to answer was: "What are the best funds to purchase?"

There are many ways to define "best". Some investors may use total return as a metric, but as a retiree, risk is as important to me as return. Therefore, I define "best" as the asset that provides the most reward for a given level of risk, and I measure risk by the volatility. Please note that I am not advocating that this is the way everyone should define "best"; I am just saying that this is the definition that works for me.

Before delving into the analysis, it is instructive to briefly discuss the difference between pharmaceutical companies (referred to as "pharma") and biotechnology companies (referred to as "biotech"). Both types of companies develop and sell medicine to cure or manage diseases, so the difference is a matter of focus.

On a pure technical basis, biotech companies use knowledge of biology to change the functions of cells in a controlled and predictable way. These companies use manipulation of living organisms to synthesize drugs. In contrast, pharmaceutical companies typically rely on plant and chemical based compounds to create their products.

From a business point of view, biotech companies are more focused on research and development (R&D) to develop novel compounds that are then taken to clinical trials. Biotech companies often operate at a loss until the new drug is approved. Pharma companies also do R&D, but typically have a stable of drugs that can be sold while waiting for the next blockbuster to be developed. Conventional pharma firms tend to be profitable, which may not be the case for the smaller biotech firms.

Adding these traits together means that biotech companies have a higher degree of risk than their chemical-based cousins. The stock price of biotech may be highly volatile depending on the results of a clinical trial. Thus, shareholders of biotech companies have the potential for large losses as well as large gains. Pharma companies are somewhat more predictable and are less volatile.

My objective in this article was to analyze the risk-to-reward characteristics of both pharma and biotech funds. I wanted to analyze performance over a complete market cycle, so I restricted my analysis to funds that were launched prior to 12 October, 2007 (the start of the bear market). I also required at least a moderate liquidity, with an average volume of at least 50,000 shares trading each day. I did not include leveraged or inverse funds in this analysis. The following funds satisfied my criteria.

  • PowerShares Dynamic Pharmaceuticals (PJP). This ETF focuses on large cap pharmaceutical companies. It is a "quant" fund that uses a 50 factor proprietary model to rank stocks in terms of capital appreciation potential. The fund contains 30 stocks. This is a market cap weighted fund, but because of its construction, the largest holding seldom exceeds 5%. It is rebalanced quarterly. It has an expense ratio of 0.6% and has a small yield of 0.4%.
  • SPDR S&P Pharmaceuticals (XPH). This ETF tracks 30 pharmaceutical companies selected from the S&P Total Market Index. It uses an equal weight methodology with about equal amounts in large-cap, mid-cap, and small-cap companies. This ETF has an expense ratio of 0.4% and yields about 0.6%,
  • iShares Nasdaq Biotechnology (IBB). This ETF tracks the Nasdaq Biotechnology Index that consists of 118 stocks, with over 75% in the biotech arena. About 50% of the total assets are in large-cap companies, 30% in mid-cap, and 20% in small-cap. The fund has an expense ratio of 0.5% and does not have a significant yield.
  • SPDR S&P Biotech (XBI). This ETF consists of 56 equally weighted U.S. companies. About half of the holdings are "early stage development," firms that are focused on pure research with no drugs on the market yet. This emphasis on small-cap stocks has made XBI the most volatile fund of the group. It has an expense ratio of 0.4% and has a small yield of 0.2%
  • First Trust NYSE Arca Biotech Index (FBT). This is an equal-weight ETF consisting of 20 US biotech companies. The portfolio consists of mostly mid-cap and small-cap firms and is rebalanced quarterly. This ETF has an expense ratio of 0.6% and does not have a significant yield.
  • PowerShares Dynamic Biotech & Genome (PBE). This ETF is a "quant" fund based on an "Intellidex" index. The proprietary Intellidex methodology selects 30 companies based on price and earnings momentum, management, and value assessments. About 66% of the portfolio is invested in biotechnology, and most of the rest in life science companies. Only about 25% of the portfolio is large cap with the rest divided equally between mid-cap and small-cap. The expense ratio is 0.6%, and the fund does not have a significant yield.
  • H&Q Healthcare Investor (HQH): This price of this CEF has oscillated between a small premium and a small discount. Over the past year, the average discount has been 1%, but the fund is currently selling at a 2% premium. It has 90 holdings focused on healthcare, with an emphasis on biotechnology and pharmaceuticals. It does not use leverage, but many of holdings are smaller, emerging companies. The expense ratio is a high 1.3% and the distribution rate is an excellent 6.7%,
  • H&Q Life Sciences Investors (HQL). This CEF sells at a 4% discount which is less than its average discount of 1.6%. The fund has 94 holdings that focus on both biotech and pharmaceuticals, with more emphasis on biotech companies. The portfolio shares some companies with the HQH, its sister CEF, but it is only about 84% correlated. The fund does not use leverage and has a high expense ratio of 1.4%. The distribution rate is 7%.

To evaluate the risks and rewards associated with these funds, I plotted the rate of return in excess of the risk free rate (called Excess Mu on the charts) versus the volatility of each fund. For comparison with the overall stock market, I also included the SPDR S&P 500 ETF (SPY). The results are shown in Figure 1 and were generated using the Smartfolio 3 program (www.smartfolio.com).

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Figure 1: Reward and Risk over cycle (10/12/07 to present)

The Figure indicates that there has been a wide range of returns and volatilities associated with these funds. For example, FBT has generated a high rate of return, but at the expense of increased volatility. Was the increased return worth the increased volatility? To answer this question, I calculated the Sharpe Ratio for each ETF.

The Sharpe Ratio is a metric, developed by Nobel laureate William Sharpe that measures risk-adjusted performance. It is calculated as the ratio of the excess return over the volatility. This reward-to-risk ratio (assuming that risk is measured by volatility) is a good way to compare peers to assess if higher returns are due to superior investment performance or from taking additional risk. On the Figure, I also plotted a red line that represents the Sharpe Ratio of XPH, which is a broad based pharmaceutical fund. If an asset is above the line, it has a higher Sharpe Ratio than the XPH. Conversely, if an asset is below the line, the reward-to-risk is worse than the XPH. Similarly, the blue line represents the Sharpe Ratio of IBB, a comprehensive biotech fund.

Some interesting observations are apparent from the plot. First off, both the pharma and biotech funds had much better performance than the S&P 500, not an easy feat to accomplish. Pharma funds had the least volatility of the group, even lower than SPY.

The pharma group had the best risk-adjusted returns. PJP had the best performance, but XPH was close behind. In general, over the complete cycle, the pharma group had significantly better risk-adjusted returns than the biotech funds. This may be because pharma stock hold up relatively well in a bear market, since people will purchase prescription drugs regardless of the economy.

The closed end funds HQH and HQL were more aligned with the biotech ETFs than the pharma ETFs. If we focus on the biotech group, IBB had the best risk-adjusted return, with HQH close behind. PBE was the laggard of the group.

Next I wanted to assess how much portfolio diversification I might receive by investing in these funds. To be "diversified," you want to choose assets such that when some assets are down, others are up. In mathematical terms, you want to select assets that are uncorrelated (or at least not highly correlated) with each other. I calculated the pair-wise correlations associated with the selected funds. The results are provided as a correlation matrix in Figure 2.

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Figure 2. Correlation matrix over the cycle

As is evident from the matrix, the biotech funds provide moderate diversification when compared to the S&P 500, with correlations in the 70% to 77% range. The pharma funds offer a little less diversification, with correlations around 80%. The closed end funds also provided moderate diversification when paired up with the other funds. As you might expect, the biotech funds had high correlations in 85% to 90% range when compared with their peers. A similar conclusion applied to the pharma funds. This data suggests that you can receive diversification benefits by adding a pharma fund, a biotech fund, or one of the closed end fund to your general stock market portfolio. However, you do not receive a lot of benefit from purchasing multiple funds from the same class of assets.

We have seen that both the pharma and biotech funds had outstanding performance over the entire bear-bull cycle. Did this outperformance continue during the recent bull market? To answer this, I analyzed the past 3 year period and the results are presented in Figure 3.

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Figure 3: Reward and Risk for past 3 years

Surprisingly the outperformance continued, even though the S&P 500 was in a strong bull market. In this case, the pharma funds still generated excellent risk-adjusted returns, with PJP having the overall best risk-adjusted performance. IBB continued to lead the biotech funds, with the two closed end funds (HQH and HQL) close behind. The other three biotech funds (PBE, FBT, and XBI) lagged on a risk-adjusted basis.

Finally, to obtain a very near term perspective, I re-ran the analysis for the past 12 months. The results are shown in Figure 4.

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Figure 4: Reward and Risk for past 12 months

Again, the pharma and biotech funds outpaced the S&P 500, with the pharma funds XPH and PJP booking the best risk-adjusted performance. Interestingly, over the near term, PBE had an excellent run and beat out IBB in the biotech group. The other four funds (FBT, XBI, HQH, and XBI) had a risk-adjusted performance similar to the S&P 500 but lagged the other pharma and biotech funds. It is worthy of noting that PBE and IBB had outstanding returns on both an absolute and risk-adjusted basis.

Bottom Line

Both pharma and biotech funds have had shown excellent risk-adjusted performance over the preceding several years. No one knows what the future will bring but based on the past, I would give the nod to PJP as the best pharma fund and IBB as the best biotech performer.

Source: Selecting The Best Pharma And Biotech Funds