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By Robert Goldsborough

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 (OTCQX:RHHBY) acquire Genentech and Sanofi (SNY) gobble up Genzyme; and Morningstar equity analysts see several other biotechs as likely takeout targets, including Biogen Idec (BIIB), Seattle Genetics (SGEN), Actelion, Exelixis, and BioMarin (BMRN).

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 (IBB)
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.

SPDR S&P Biotech (XBI)
The second-largest and second-most liquid biotech ETF, XBI offers much higher-beta exposure because it tracks an equal-weight index of 43 biotech firms. As a result, it provides much more exposure to small- and mid-cap stocks than a cap-weighted fund like IBB. XBI, whose index recently expanded, also owns only a handful of established biotech companies. Nearly half of its holdings are early-stage players with no drug on the market yet and that therefore are devoid of profitability. The smaller firms and their decidedly uncertain prospects but explosive upside potential definitely loom larger and have a meaningful sway on the portfolio. The fund has done well over the last few years, rising almost 60% in that time period (and topping all but one of its biotech ETF peers), compared with the S&P 500's anemic rise of just 2.4%. XBI significantly underperformed in 2009 (when it was basically flat, compared with the S&P 500's 23.5% increase), but has had good performance in other years. One nice attribute for investors is the fund's 0.35% expense ratio--the lowest of all traditional biotech ETFs. Because Morningstar equity analysts follow just half of the assets in this ETF, we are not able to provide a fair value for it.

First Trust NYSE Arca Biotech Index (FBT)
Like XBI, this is an equal-weight ETF, meaning that upstarts sit shoulder-to-shoulder with established players like Biogen Idec, Amgen (AMGN), and Celgene (CELG). This fund also is the second-most concentrated biotech ETF, holding just 20 biotech firms. With a 0.60% expense ratio, FBT is one of the most expensive biotech ETFs, and it's easy to question the potential upside for investors at these levels, given that the fund trades at 99% of its fair value. At the same time, this has been the best-performing biotech ETF by far over the last five years, rising an explosive 113%. That includes a 45% gain in 2009 and a 37% increase in 2010.

Biotech HOLDRS (BBH)
Although this quirky fund trades on an exchange, it does not track an index, unlike traditional ETFs. And holdings are static, reflecting solely the selections that its parent, a Bank of America Merrill Lynch subsidiary, made at launch. As a result, this is a highly concentrated (just 12 names) fund that devotes more than 85% of assets into just three large biotechs: Amgen, Gilead Sciences (GILD), and Biogen Idec. Amgen alone makes up more almost 36% of the fund. We like the cost structure of a HOLDRS fund--they charge annual custody fees of $0.08 per HOLDR share, which converts to an expense ratio of anywhere from 0.02% to 0.05%. Like its peers, BBH has outperformed the broader market significantly over the last five years; however, it has significantly underperformed competing biotech ETFs during that same interval. We would attribute that to its heavy concentration in larger names; investors in this fund see less volatility but also are deprived of the potential for explosive gains from individual portfolio companies that enjoy drug approval. BBH also trades at a slightly less expensive valuation than the other biotech funds that Morningstar values. Currently, it trades at 92% of fair value.

PowerShares Dynamic Biotech & Genome (PBE)
Like XBI, this is an equal-weight ETF with a higher exposure to small- and mid-cap biotechs, many of which are early-stage players with no drug on the market yet. In addition, this ETF tracks a dynamic (as in, changing often) benchmark that selects and ranks biotech stocks based on capital appreciation. The index is governed by a quantitative-active model that aims to surpass the returns of traditional indexes by investing in stocks that display favorable fundamental growth, attractive valuations, and momentum traits. This ETF charges a 0.63% expense ratio, which is higher than several competing ETFs, but eminently reasonable for a fund that can outperform its rivals. This fund has done well over the last five years (up 36%) and in the last few years in particular (up 31% last year alone, versus a 13% increase for the S&P 500). Unfortunately, Morningstar does not cover enough of the assets in this ETF to be able to provide an estimate of its fair value.

So, which biotech ETF would we recommend?

In looking closely at the five funds, we would encourage investors to focus on cost, portfolio construction and risk, recent performance, and if available, valuation. Right out of the gate, we would dismiss the HOLDRS and PowerShares offerings. We like the BBH's price tag and its current valuation, but it has posted pretty weak performance relative to the other funds over the last few years, and we don't think the biotech space is the place to be for such heavy portfolio concentration. PBE charges a high price tag, and investors should expect to receive superior performance for that cost. In recent years, they haven't--at least, not relative to peer ETFs.

We also would dismiss the iShares fund. We like its liquidity and its portfolio diversity, but it has a higher price tag and a fairly rich valuation, and its five-year performance is below that of two of its other peers.

That leaves the SPDR and the First Trust offering. For more conservative investors, we would recommend the SPDR (XBI), given its low beta relative to its peers, its very strong recent performance, its low price tag, and its portfolio diversity. For a more risk-seeking investor, we would recommend FBT, which has posted incredibly impressive performance over the last few years. FBT is a perfect example of a higher-priced fund that thus far has earned its fee. At the same time, we worry about the concentration in FBT, which holds just 20 firms, and the fund's currently fairly rich valuation, and we would urge investors to tread carefully with this ETF.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), 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.

Source: Narrowing Down the List of Biotech ETFs to 2 We'd Recommend