Few sectors in the stock market can be as risky and rewarding as the biotechnology sector. Investors in this sector are banking on more than just corporate fundamentals to see a pay-off on their investment. Some companies have greatly rewarded investors, such as Biogen Idec (NASDAQ:BIIB). Others have yet to see their best days, such as Human Genome Sciences (HGSI). And others have shocked investors, such as Orexigen (NASDAQ:OREX) and Dendreon (NASDAQ:DNDN). Investing in biotechnology is similar to walking across a minefield. You never know just when it could explode in your face. But, we believe we have found a good solution to this vexing dilemma, one that will allow long-term investors to benefit from the unique opportunities of the biotech sector while minimizing their risk.
ETF's have long been a great way to diversify your portfolio and reduce risk and generate alpha over the long run. The same principle applies in the biotech sector. However, when were looking into the traditional biotech ETF's, we encountered a dilemna. The top 2 ETF's in this sector, the iShares NASDAQ Biotechnology Index Fund (NASDAQ:IBB) and the SPDR S&P Biotech ETF (NYSEARCA:XBI) have far too many holdings to make them worthwhile. While they are good at diversifying, the biotech sector is not one people invest in to reduce risk. It is an investment designed to maximize growth. To achieve that, we chose to invest in the First Trust NYSE Arca Biotechnology Index Fund (NYSEARCA:FBT). What makes this fund unique, in our opinion, is that it has just 20 holdings, compared to dozens of holdings in the XBI and IBB. To us, this strikes the proper balance between diversification and de-risking.
One of the most attractive features in this ETF is that does not overweight any of the Big 4 biotechs. Currently, Celgene (NASDAQ:CELG) is the largest Big 4 holding, representing just over 6% of the ETF. By comparison, Amgen is the top holding at IBB, at 7.17%. XBI is better, for it has Celgene as its top Big 4 holding at 3.55%. However this is still not as good as FBT, for at the other 2 ETF's, any benefits from lower exposure to the Big 4 biotechs is lost in the sheer number of holdings.
At the First Trust ETF, the big 4 biotechs represents about 23.5% of the fund, which strikes a good balance between stability and growth. The other 75% of the fund is spread amongst small and mid cap biotechs in various stages of product development, ranging from Alexion to Regeneron. The choice of restricting the ETF to just 20 holdings allows for each holding to provide a meaningful impact to the fund's performance. Although this can cause the fund to underperform at times, over the long term it will result in continued outperformance. The fund and its underlying index are rebalance quarterly, allowing for new stocks to be added should the need arise.
One of the most important aspects of any ETF is it's expense ratio. It is here that investors may be put off. The First Trust Biotech Index Fund's expense ratio is 0.6%, compared to 0.48% for the iIBB and 0.35% for the XBI. But should this deter investors? We do not think so. This ETF's track record speaks for itself.
Since its inception, this ETF has dramatically outperformed its more diversified counterparts. We will not shy away from the fact that this fund may underperform them in the short-term. But, for investors with a longer-term time horizon and the patience to wait, we feel that this fund will be rewarding. It may be more risky than a more diverse biotech ETF, but it is certainly less risky than investing in any one biotech stock. And to us, that is a proper balance. It is a balance that has been rewarding to us, and one that we believe will be even more rewarding in the future.