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By Robert Goldsborough

The U.S. biotechnology sector has enjoyed an impressive run during the past decade. The industry has dramatically outperformed the broader market over that time frame and also had a tremendous 2013. Large-cap biotech firms have fueled this rally, as they have scored key drug approvals, reaped strong sales from already-approved drugs, successfully integrated acquisitions, and benefited from a favorable regulatory environment. The sector also has seen valuations surge from merger and acquisition activity, as large pharmaceutical firms have sought to spruce up relatively empty drug pipelines by buying innovation in the form of biotech firms.

The biotech sector's performance has hit a bit of a lull during the past three months, with exchange-traded funds devoted to the biotech sector sliding anywhere from 8% to 20%, even as the broader market has risen nicely. The sector has been pressured by pricing concerns that were sparked by Gilead Sciences' (NASDAQ:GILD) launch of a popular hepatitis drug. That release sparked congressional interest in justifying the pricing for the drug. In addition, a large pharmacy benefit manager began openly discussing restricting the use of that drug once competition enters the market late this year. Those two actions sent ripples throughout the entire industry, making investors fearful of potentially increased governmental regulations on pricing and PBMs' increased leverage for discounting in the private market.

The recent price pressure may present a buying opportunity for investors interested in biotech firms. One ETF that offers a way to tap into larger biotech firms is iShares Nasdaq Biotechnology (NASDAQ:IBB). This fund holds 122 biotech firms listed on the Nasdaq with market caps of at least $200 million. More than 20% of assets are invested in small-cap names that apply innovative techniques to research, develop, and commercialize various drugs targeting certain diseases or therapeutic niches. The jarring pace of change, single-product liability, regulatory uncertainties, and intellectual property rights make picking stocks in the biotech sector a high-risk/high-reward proposition. As such, we think investing in the industry via an ETF makes a lot of sense; it's a low-cost way to gain diverse exposure with one trade. And this particular ETF may be best suited for investors looking for as much diversification as possible; IBB has the broadest number of holdings of any biotech ETF currently trading.

Unlike several competing biotech ETFs that track equal-weight indexes, this fund tracks a market-cap-weighted index, which ensures that the more established, larger-cap biotech firms hold more sway. As a result, IBB has been less volatile during the past five years than any other biotech ETF and has been less volatile than all but one actively managed biotech mutual fund. While an equal-weight strategy may sound like a reasonable choice for a lotterylike industry such as biotechnology, a cap-weighted strategy has resulted in better risk-adjusted returns across one-, three-, five-, and 10-year time periods.

Fundamental View
To win regulatory approval for a drug, a biotech company must take its therapy through a 10- to 15-year research and development gantlet in a process that costs $1 billion on average. After all that, success rates are low. Only about 20% of drugs reaching Phase I of clinical development ever actually hit the market. With all these factors, many smaller biotech firms don't turn a profit. Many give up their drugs' marketing rights to industry giants in exchange for royalties on sales and even cash upon reaching certain development milestones. The upshot: A biotech firm that can successfully bring its products to market will reap bountiful rewards, grow significantly, and create an instant economic moat.

One issue facing the biotech industry is health-care reform. Medicaid started covering more people in 2014, which should be a positive for volumes and the drug industry. On the negative side, higher rebates already are in place for Medicaid patients, which means biotechs will see lower net prices for their drugs. That said, we think the positives from health-care reform far outweigh the negatives for the biotech sector.

Merger and acquisition activity also has helped boost biotech firms' valuations. Large pharmaceutical firms have sought to boost their drug pipelines in part by buying up biotech firms. Given Big Pharma's flush balance sheets, we expect more biotechs to be acquired by large pharmaceutical firms in the near term.

From a reimbursement standpoint, we like that most biotechs tend to focus on biologics that address serious, chronic, or life-threatening illnesses; this means that both government and private insurers will in fact reimburse as medical benefits the highly profitable infused drugs approved to treat major ailments. We also like that biotechs remain less vulnerable to generic competition than Big Pharma because of the difficulty of manufacturing, the cost of clinical trials, and the still-developing pathway for these products in the United States.

In our view, the biotech industry is much less susceptible to government intervention than other health-care subsectors--like hospital operators or managed-care organizations. Certainly, the recent activity surrounding Gilead's hepatitis drug has revealed that biotechs are hardly immune to the prospect of government regulation or PBMs' growing leverage with pricing. At the same time, we expect biotechs that release very innovative drugs should have little problem receiving reimbursement from the government and private payers. And we think an ETF is the appropriate tool for investing in this notoriously volatile subsector. One drug's odds of success typically have no bearing on another's; we like the diversification among individual firms that this fund offers, which helps protect against single-stock risk.

Portfolio Construction
IBB tracks the Nasdaq Biotechnology Index, which encompasses 122 Nasdaq-listed stocks that are either biotechnology or pharmaceuticals firms, as defined by the FTSE and Dow Jones' Industry Classification Benchmark. As a practical matter, IBB is a biotech-heavy ETF both in name and in focus, with about 77.5% of assets invested in firms that are classified as operating in biotechnology. The remaining 22.5% of assets are invested in small- and mid-cap pharmaceutical firms such as Mylan (NASDAQ:MYL), Salix (NASDAQ:SLXP), Theravance (NASDAQ:THRX), Verastem (NASDAQ:VSTM), Cellular Dynamics International (NASDAQ:ICEL), and Curis (NASDAQ:CRIS); the U.S.' largest pharmaceutical firms trade on the New York Stock Exchange. IBB's index is one of eight subsectors that make up the Nasdaq Composite Index. While each firm must have an average daily trading volume of at least 100,000 shares and a minimum market cap of $200 million, the portfolio spreads its assets across the market-cap range, with about 59% of assets in large caps, 21% in mid-caps, and 20% in small caps. The fund tracks a cap-weighted index and invests 59% of assets in its top-10 holdings. The holdings-weighted average market cap is $15.3 billion.

Fees
IBB's 0.48% expense ratio is reasonable, but cheaper ETF options exist. For instance, both SPDR S&P Biotech (NYSEARCA:XBI) and Market Vectors Biotech ETF (NYSEARCA:BBH) charge just 0.35%. Still, we think that IBB's price tag is quite reasonable given the biotech-industry diversification that it offers investors. What's more, IBB's estimated holding cost is a more attractive 0.26%. Estimated holding costs are primarily composed of the expense ratio but also include transaction costs, sampling error, and share-lending revenue.

Alternatives
Investors seeking exposure solely to biotechs can consider SPDR S&P Biotech, which is a fairly concentrated, equal-weight portfolio. While its 0.35% expense ratio is reasonable, this fund has lagged many peers across different time frames. Its 82-stock portfolio sports a holdings-weighted average market cap of $1.8 billion.

An even more concentrated option is First Trust NYSE Arca Biotechnology Index (NYSEARCA:FBT) (0.60%), which has posted solid performance during the past five years. However, its performance has trailed IBB for the past few years, and it has displayed much greater volatility than IBB. It's also fairly pricey. FBT holds 20 biotech firms and clocks in at an average market cap of $10.1 billion.

Two other ETF options are PowerShares Dynamic Biotech & Genome (NYSEARCA:PBE) (0.63%) and Market Vectors Biotech BBH (0.35%). The Market Vectors ETF is more of a traditional cap-weighted fund, holding the largest biotechs (think Gilead, Amgen (NASDAQ:AMGN), Celgene (NASDAQ:CELG), and Biogen Idec (NASDAQ:BIIB)). As a result, BBH's portfolio of 25 biotech stocks has an average market cap of $23.7 billion. For a quantitative-active approach to the biotech subsector, investors also can consider PBE, which holds 30 names and has an average market cap of $6.5 billion.

There also are several actively managed, open-end mutual funds offering exposure to biotech that investors might want to consider. These include Bronze-rated Fidelity Select Biotechnology (FBIOX) (0.75%), Rydex Biotechnology (RYBOX) (1.61%), and Franklin Biotechnology Discovery (FBDIX) (1.20%). However, the performance of these funds largely has lagged IBB's during the past one-, three- and five-year time frames.

Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.

Source: An ETF For This Lagging Sector