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Biotechnology is a limitless resource. We may run low on oil or gold, but priceless high-technology medical discoveries will continue to be found, as well as people willing to pay the prices. In June of 2011, Morningstar analyst Robert Goldsborough wrote a very helpful brass-tacks article called Narrowing Down the List of Biotech ETFs. Writing for October of 2011, I agree with Mr. Goldsborough's conclusion that for most investors, XBI and FBT seem clearly the lead choices, but perhaps this could be narrowed further. Starting with the general picture, here are the top contenders.

Click to enlarge

Best biotech ETFs--click to enlarge.

Volume Fee Stocks Age
IBB $6.5 mil 0.48% 125 10 yrs
XBI $1.4 mil 0.35% 45 5 yrs
FBT $0.5 mil 0.60% 20 5 yrs

IBB, the iShares Nasdaq Biotechnology Index Fund, is by far the oldest and most popular biotech ETF. Current IBB 5-year returns are above the S&P, but primarily due to losing less in 2008. This apparent stability also cannot be depended on. Returns for 2002 were -45%, much worse than the S&P and even its own healthcare category. Altogether, IBB performance seems about equal to the S&P, with greater downside, offering little visceral competition to some general index funds such as the QQQ Nasdaq-100.

XBI, the SPDR S&P Biotech Index Fund, includes listings from the Nasdaq and other exchanges and is the second most popular biotech ETF. Every less popular biotech fund has much lower volume, higher overhead, and is much less diversified.

FBT, the First Trust NYSE Arca Biotech Index Fund, with its modest $0.5 million volume and immodest 0.60% overhead and only 20 stocks, might easily be dismissed - except for one thing, its stellar returns. As announced in a June, 2011 article at Nasdaq.com, the difference as of June, 2011 (before everything plummeted recently) was a whopping 5-year average of about 17% annually for FBT vs. around 9% for both IBB and XBI.

The primary secret to success claimed by the FBT managers was the equal-weighting of component stocks. But XBI is equal-weighted and currently holds 14 of the 20 stocks in FBT. So one might wonder, why hold FBT? It seems natural to assume the smaller portfolio is more risky and had beginner's luck. Mr. Goldsborough's conclusions:

For more conservative investors, we would recommend the SPDR ((NYSEARCA:XBI))... For a more risk-seeking investor, we would recommend FBT... 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.

My initial instinct was similar. However, I wondered if there might be obvious differences in the quality of FBT selections? First, using six popular rating systems, I compared the numbers of stocks with a net sell vs. a net buy. Then I roughly estimated company ages and market capitalizations.

Corp. Ratings Sell Buy Neutral
Shared Core 4 8 2
FBT Add-ons

4 1 1
XBI Add-ons

22 4 5
Corp. Ages Average 1-5 yrs 1-9 yrs 10-12 yrs 13 yrs +
Shared Core 17 yrs. 0% 0% 21% 79%
FBT Add-ons

13 yrs 0% 0% 50% 50%
XBI Add-ons 13 yrs 19% 32% 23% 45%
Corp. Mkt $'s Average Micro Small Medium Large
FBT Totals $5.0 bil 10% 23% 46% 21%
XBI Totals $2.4 bil 15% 48% 21% 16%

This is only an initial survey but the tendencies are striking:

  1. Both funds have the same "shared core" of 14 stocks capable of enough cash flow to be buy-rated by a 2:1 ratio.
  2. Any additions seem to dilute this "shared core" with sell-rated stocks at a 4:1 or 5:1 ratio.
  3. XBI is adding a much higher dilution of sell-rated companies.
  4. XBI is playing much younger companies.
  5. XBI is playing much smaller companies.

The famous motto of Holdem Poker is, "Any two cards can win." However if not pressured by game conditions, it is ideal to play with only 10s and royal cards and sit out most games. This is what FBT seems to be doing.

Volatility? XBI only lost about -8% for calendar 2008, while FBT lost -18%. But where a chart ends up on December 31 is largely luck. The "worst 3 months" posted at TD Ameritrade are -24% for XBI and -28% for FBT, both around January of 2009. XBI had fewer positions then, and holding more stocks generally adds stability. However, young stocks or penny stocks add instability. A detailed comparison seems almost a wash for XBI in this regard. And when we see that IBB's 125 positions for 2002 lost twice as badly as the S&P, then for the quirky biotech sector, perhaps the whole idea of more-is-safer is not a very safe assumption.

Liquidity? XBI is three times as popular and holds about twice the positions, but FBT positions have twice the capitalization. So FBT may take more minutes to trade but at the end of the day, both may have about the same level of ability to absorb trade volumes.

On the other hand, for its first three years, FBT performance did not establish any lasting trend above IBB. Its impressive performance depends heavily on the last two years. Success over such a time period may indeed have been luck. FBT has taken a strong lead, though which it might eventually lose. The jury is still out for FBT.

However, XBI is almost convicted of mediocrity. With IBB's long-term chart line being less enticing than the Nasdaq-100, we are looking for a line that dances increasingly apart, like the flame from a twig when starting a successful campfire. Instead the flame routinely peters down to an ember. The moderate initial success might also have been boosted by luck, honeymoon enthusiasm or XBI then holding fewer stocks. I believe XBI will continue its intermittent success pattern, but cannot say it is much of a success. The good news for XBI is only that it is well proven seldom to do worse than IBB.

In conclusion, I agree with Mr. Goldsborough that FBT is a choice for risk-seekers, but cannot agree that XBI is less risky. The only conservative choice for Biotech ETF investors is to balance any investment between FBT and XBI, or simply to invest half as much in FBT. For a relatively good time to buy, using the IE browser, set the XBI price chart at Nasdaq.com to "maximum" and "compare to IBB." Up until now, any time that XBI is touching IBB, an investment in either XBI or FBT has been likely to offer net gains as well as to outperform IBB.

Disclosure: At submission date (October 20, 2011), my website features the following publicly mirrored live accounts:

• Best Low Risk ETF Strategies: Currently will not hold FBT or XBI but may reconsider during quarterly evaluations. Around early November will begin holding QQQ during favorable trends.

• Best Biotech Stocks: During the next three months may begin holding many of the same component stocks as FBT and XBI.

Source: Comparing The Best Biotech ETFs