Investing in Biotech ETFs

If one were to look at the chart below, one would have to assume that investing in the biotech industry has been a wonderful thing, especially for the past few years (click all charts to enlarge):

Well, take a close look. Yes, the Amex Biotechnology Index [BTK] has increased over the past 13 years by more than tenfold, but, as one can see in the bottom panel, it lagged the overall stock market from its 1992 debut until the end of the Asian Crisis and Long-Term Capital challenges in 1998 by a stunning 75%. Of course the rise subsequently has been meteoric, even with the over 50% retracement of part of the 2-year bull market from 1998-2000 over the following two years. Do any of these companies produce any cures for arrhythmia? For all the volatility, the index has beaten the overall market by just 23% since its inception (and less if one includes dividends).

The discussion above addresses an index only. Investors are faced with the challenge of picking stocks or choosing from a few ETFs. If one is going to pick stocks, keep in mind that early-stage companies are like lottery tickets. You will need an Onyx (ONXX) to pay for several other losers that you will no doubt buy as well! The ETFs in the space all have issues that investors must reconcile. As one can see in the chart below that compares the BTK with a few of the offerings, the performance differs greatly and is highly variable. As I will discuss, the components and the weightings are the source of these differences. I did exclude intentionally two smaller ETFs that don’t trade significant volume, and I may have missed some new offerings as well.

First, examining the index, we find that it has a mix of companies that includes both the very large biotech companies as well as some “tools” companies. Additionally, the index is equal weighted, which is a great risk diversifier as well as a potential catalyst for higher returns (if smaller companies produce higher returns, that is).

Source: Amex Website

The Biotech HOLDRs (BBH) is the grand-daddy of the ETFs, as it was unveiled in late 1999. Why didn’t anyone think of this in 1994 or at least late 1998? Surely it was a sign of the imminent top! At any rate, BBH has been a horrible performer for two years:

As one can see in the list below, the index is cap-weighted. The large companies have underperformed greatly over the past two years. Additionally, the index is restricted solely to therapy manufacturers, which leaves out some great tools and diagnostics companies. This ETF is fixed and there are no additions. Three names were removed recently due to acquisition (Medimune, Chiron and Icos), and two were removed earlier (Immunex and BioChem). BBH trades actively, but unless one wants to invest in primarily the very mature companies (DNA, AMGN, GILD and BIIB make up 83%), it is inferior.

Source: HOLDRs website

I-Shares NASDAQ Biotech Index Fund (IBB) was the second launched ETF for the sector and is still underwater. It is the most actively traded of the group. Performance has been awful relative to BTK:

This one is NASDAQ stocks only, and lots of them. The table below includes only those with a 1% or greater weighting. Again, the big ones get counted extra, which has hurt. Though not recently, the absence of DNA has hurt this one relative to BBH. This one is proof that marketing may get assets, but that doesn’t mean it’s the best game in town.

Source: Barclays Website

The SPDR S&P Biotech (XBI) is my favorite, and it’s not because the performance has been great this year after a bad year last year:

Launched almost two years ago, this ETF still has relatively low trading volume. I would bet that performance-chasers will take note and perhaps look into the superiority of this product for the biotech space. The ETF is rebalanced quarterly and is equal-weighted. It also includes a few diagnostics companies, including one that I really like, Myriad Genetics (MYGN).

Source: State Street Website

It is a shame that Amex partnered with little-known First Trust to offer an ETF based on BTK. First Trust ETF Amex Biotech (FBT) trades just 38k shares ($1mm) per day. It tracks the index precisely but has relatively high expenses (.60% being charged until June 2008, but this is subsidized and could rise). So, if you are one that believes that an ETF is the best way to play biotech, I recommend that you consider XBI.

Disclosure: I own no ETFs mentioned, but I do own CELG, a very recent purchase.

Comments

[alan buchanan:]

Surely its till a good market to invest in even though the great growth its seen?

May 25 12:23 PM

[elottery:]

Obviously a quality stock

Jun 08 10:52 AM