In October of 2011, I posted an article, "Comparing the Best Biotech ETFs." I concluded that in my opinion, XBI and FBT are the most suitable biotech ETFs for most investors, with FBT slightly more promising. Also that XBI and FBT might be combined for a favorable profile. Now in January 2012, this multi-factorial analysis needs to be updated. However in this article, I would like to focus only on the visual analysis of performance graphs. Here is my approach.
1. Emphasis on long term and log scale. I like to have at least one 5-year period before forming any opinions, and preferably multiple 5-year periods. Although depending on available data, I might use anything from 3-year to 20-year periods. I like to include at least one recession year and one recovery year, and strictly avoid having one without the other. Also, I use "log scale" graphs for accurate visualization. In log scale, within the same graph, every 1/4" of drop is always the same percentage of drop.
2. The importance of "net performance." The Nasdaq 100 is a good example for graphic analysis because we can take a 20 year perspective. It seems to me that the Nasdaq 100 (or its fund QQQ) has superior net performance to the S&P 500 (or its fund SPY) although both are general indexes. How did I form this opinion? Admittedly, I dislike the huge bubble that the Nasdaq 100 formed around the year 2000. Nonetheless in spite of this bubble, the Nasdaq 100 chart line has consistently increased its average distance above the S&P 500 over 20 years. Of course, the year 2000 was a terrible time to begin playing the Nasdaq, and right now also is a questionable time. Perhaps new factors also may adversely affect the Nasdaq 100. Otherwise however, with just common sense and some basic precautions such as semi-annual rebalancing -- in my opinion we can expect eventually to lock-in more gain from the Nasdaq 100 than from the S&P 500.
The Russell 2000, on the contrary, exhibits strong "entrainment" to the S&P 500. Whatever gain either one has, it seems destined to lose every few years. I personally prefer the Russell 2000 over the S&P 500, because I use various strategies to take advantage of volatility. Fundamentally however, neither one is superior to the other in net performance. Meanwhile the Nasdaq 100 is fundamentally superior to both. (Data source: Finance.Yahoo.com.)
3. Limitations of graphic performance comparisons. In my opinion, looking at performance graphs is more meaningful when comparing mutual funds or investment systems than when comparing individual stocks. Also of course, gold, oil, gas, banking, etc., all can have good decades and poor decades. So beware for example of anyone claiming to have an infallible system based on a 5 year winning streak as a commodities trader. Similarly, we know that the Nasdaq 100 does not include financial sector corporations, which have been troubled lately, and which situation could change. But within common sense parameters, it is reasonable to use graphic performance to compare related indexes. Also we can refer to the S&P as a benchmark for all indexes. Also we certainly can apply graphic performance analysis in comparing two biotech index funds.
The goal is not to predict anything -- but simply to determine whether one system 'A' might be inherently more efficient than another system 'B'.
4. Circumstantial evidence: entrainment and extrapolation. We must be tentative about any results based on one 5-year period, which is all we have for most biotech funds. However, until we have more data, we can extrapolate, or you might say guess-timate, beyond the 5-year period by remarking the degree of entrainment to the most-traded biotech index fund IBB -- which has a 10-year history. During its 5-year history, XBI very consistently shows a tendency to do better than IBB -- but also to return to rejoin IBB. I do not see how either tendency repeated this consistently can be achieved by chance. This gives us reason to hope that XBI is a little better than IBB -- but also that any time XBI gains more than IBB, it is destined soon to lose almost all of that gain. So far, XBI and IBB exhibit significant entrainment.
Meanwhile -- looking at the next graph below -- IBB did much worse than the S&P during the first half of its 10-year history. During the second 5 years, IBB has been doing much better. The net total is about equal to the S&P. Therefore IBB seems not especially promising. Therefore XBI which is entrained to IBB is not likely to be much better. Why dabble in a high-risk sector when it might be no better than the S&P?
On the other hand, note also from this same chart that IBB seems somewhat entrained to the Nasdaq 100. Both were probably over-compensated downwards by the bursting of the tech bubble of the 1990's. Perhaps we should judge both starting in 2004, after the over-compensation period. We then have reason to be hopeful. However by the same token, please note that IBB has not outperformed the Nasdaq 100, but is at best equal. Meanwhile the Nasdaq 100 is not a biotech index, but more diversified and more proven. IBB might not have gained much distinction from its biotech emphasis, but mainly some added risk and uncertainty.
If we simply believe theoretically in the biotech sector, then we certainly can give XBI the benefit of the doubt. However, by the same token, if our hunch is true that the biotech sector is fundamentally strong -- shouldn't we in theory hope to find something with a more clear indication of possible superiority over IBB? And therefore a more clear indication of possible superiority over the S&P.
5. An answer found in non-synchronicity. In a somewhat unexpected manner, looking at performance graphs eventually answered my quest for biotech investments that might consistently outperform IBB. Note these two obvious facts.
- From a long term perspective, neither FBT nor XBI has had any significant downswings relative to IBB.
- In addition, FBT and XBI are significantly non-synchronized. They have had significant upswings at significantly different times.
Therefore whichever of these two funds has done less well lately also seems destined to lose proportionally less. Therefore if each fund systematically donated its gains to the other, this would systematically lock-in some of these above-benchmark gains. Therefore a 50/50 combination of XBI + FBT seems likely to result in an ever-increasing average distance above IBB -- if rebalanced either quarterly or semi-annually, depending on taxes and trading fees. Or of course, if you simply rebalance your entire portfolio regularly as everyone should, and allocate the same proportion to both XBI and FBT -- then a similar effect will occur.
6. Is FBT by itself a winner? Biotechnology ETFs may yet have a soloist champion in FBT -- but not yet. The FBT performance line has shown a serious potential perhaps to break from entrainment with IBB. Lately however -- after a 2-year winning streak, FBT seems headed toward losing all these gains. If a criss-cross occurs, then we will have achieved zero net performance evidence over the past 10 years that any single biotechnology ETF is especially worthwhile. We hope this will not happen, but time will tell.
FBT seems slightly more hopeful than XBI of gaining and holding some distance above IBB. For now however it seems by far the best to combine FBT + XBI.
7. Considering volatility. Some short-term investors seek high volatility, like surfers seeking waves. Others crave low volatility. However with regards to XBI vs. FBT, only FBT has the volatility or the net performance. Nor does XBI even offer significantly less volatility. So regardless of investing style, considering volatility does not seem to change the overall picture that FBT seems a slightly more promising investment vehicle.
8. Conclusions. I suspect that many investors choose XBI based primarily on how bumpy most graphs look. They might fail to use log scale. They might fail to factor in "net performance" relative to IBB, the biotech sector's most prominent benchmark. All of this is explained above, perhaps over-explained, because this is my main purpose for this article. Therefore I emphasize the following.
- From a peak in 2008, XBI lost about 1/3 of its value, which it failed to recover for almost 3 years.
- Right now this might also happen to FBT -- but not yet. Until now FBT has always recovered within one year. And even if FBT fails to recover soon from its current downswing -- its net performance still remains at least as good as XBI.
- Therefore, investors who emphasize XBI are substantially reducing possible gains while not substantially reducing risk.
- If you are risk-averse, it only makes sense either to balance between FBT + XBI or else just to reduce your FBT allocation.
- However, when FBT is flying high, look out! Avoid initiating any biotech ETF investment at times when its performance since inception is far above IBB.
- This article focusing on graphic analysis is not a complete picture. However the same conclusions seem reinforced by multi-factorial analysis, as discussed in my previous article, Comparing the Best Biotech ETFs.
- Also, it might not be necessary to buy biotech ETFs. XBI and FBT together only hold 51 stocks. Therefore investors with access to $1 trading fees and a $50,000 allocation might affordably maintain all the best components of both funds. With proper care, this might do better than any biotech ETF, without significantly adding untested parameters.
- However, most people should only allocate between 1/10 to 1/4 of their market investing to biotechnology. One thing that we certainly learn from graphs is that biotechnology investing is relatively unpredictable.