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Biotechnology is an exciting sector of the stock market, and many investors are wise to allocate some of their portfolios into this high risk, and potentially high reward area. However, not all biotech companies are created equal. Some of the major players, i.e. Amgen (NASDAQ:AMGN), Gilead (NASDAQ:GILD), Celgene (NASDAQ:CELG), and Biogen Idec (NASDAQ:BIIB), are large, multinational, profitable, relatively defensive companies. In other words, they resemble many of the large pharmaceutical companies such as Pfizer (NYSE:PFE), Lilly (NYSE:LLY), and Merck (NYSE:MRK). Other biotechs, e.g. Vertex (NASDAQ:VRTX), Biomarin (NASDAQ:BMRN), Amylin (AMLN) and Seattle Genetics (NASDAQ:SGEN), have FDA approved drugs on the market, and are cash flow positive or close to it. These companies generally sport market capitalizations of a few billion dollars. Last but not least, many biotech companies are small (under $1 BB market capitalization), unprofitable, and working on getting their drugs to market. In addition, many of these smaller companies rely on secondary offerings or partnerships, making them sensitive to prevailing market conditions. Furthermore, many of these smaller companies feature binary "catalyst" events such as clinical trial results or drug approval dates and are extremely volatile.

ETFs are a potentially low cost, tax efficient way of diversifying a portfolio without the massive, company specific risk that embodies biotechnology investments, and with such a wide variation in biotech and small pharmaceutical companies, it should come as no surprise that the ETF choices are equally as varied. Let's dive into some of the largest biotechnology focused ETFs.

Top ETFs by Market Capitalization

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IBB - The Nasdaq Biotechnology Index (NASDAQ:IBB) is the most popular (measured by volume), and largest biotech ETF. But does it provide the best exposure to the sector? That depends on your own definition of biotech. While the number of holdings is quite high, the ETF is weighted heavily towards the top 10 holdings (54%). These include the big biotechs Amgen , Gilead , Celgene , Biogen Idec , Regeneron (NASDAQ:REGN), and Alexion (NASDAQ:ALXN), but notably, the index also includes companies you would not necessarily classify as traditional "biotechs". These are Mylan (NASDAQ:MYL), Teva Pharmaceuticals (NYSE:TEVA), and Perrigo (NYSE:PRGO). The index has performed well this year, returning approximately 18%.

XBI - Like its cousin, IBB, The SPDR S&P Biotech ETF (NYSEARCA:XBI) is also large and well established. Unlike IBB, however, this ETF is not tilted as heavily towards the larger players due to its slightly modified equal weighting, and has significant exposure to smaller and midcap stocks (34% and 33%, respectively). It also does not include companies like Teva, Perrigo, or Mylan. XBI includes many companies with compounds in late stage trials, and provides exposure for investors interested in potential buyout candidates. The index has performed well this year, returning approximately 20.5%.

FBT - The NYSE Arca Biotechnology Index is an equal dollar weighted index, holding only 20 stocks, many of which are members of XBI. This is the least diverse ETF, and relatively illiquid, with only an average of 66k shares traded daily. I would be remiss if I did not point out that Vertex is 8% of the fund. The index has performed extremely well this year, returning approximately 29%, but still a few percent below its levels 1 year ago.

PJP - Even though the PowerShares Dynamic Pharmaceuticals says "Pharmaceuticals" and not "Biotechnology" in its name, I included it due to its composition of biotech stocks. The ETF tracks a modified equal weighted index, and as might be expected by the name, the fund includes the large pharmaceutical players Eli Lilly, Bristol-Myers Squibb (NYSE:BMY), Pfizer, Merck, Johnson and Johnson (NYSE:JNJ), and Abbott (NYSE:ABT), along with the largest biotech names like Amgen, Biogen Idec, Celgene, and Gilead. In addition, the fund has meaningful allocations to some smaller players such as Spectrum Pharmaceuticals (NASDAQ:SPPI), Santarus (NASDAQ:SNTS), and The Medicines Co. (NASDAQ:MDCO). The fund is surprisingly diversified for only 30 holdings, and has performed well this year, returning approximately 10%.

PSCH - The PowerShares S&P SmallCap Health Care Fund, is relatively new, debuting in April 2010. The fund tracks a float-adjusted, market-capitalization-weighted index reflecting the U.S. small-cap market, and holds 67 stocks. This fund contains many of the same names as FBT or XBI, but also includes medical device, diagnostics, and life science supply companies. The fund is small though, and an average of only 19k shares are traded daily. The fund has returned 6.5% for the year.

Conclusion

ETFs can be a great, low-cost, tax efficient way to diversify into the biotech sector, but they are not all created equal. First and foremost, it is important to understand what you are buying, because as shown above, each ETF has a very distinct composition, and therefore risk profile. If one believes that biotechnology M&A will heat up, PSCH, XBI, and possibly FBT make sense. Instead, if one believes there will be multiple expansions on profitable companies, PJP or IBB are more suitable choices. For exposure to diagnostics, and generics, and other life science focused companies, PJP, IBB, or PSCH are appropriate choices.

Source: Not All Biotechnology ETFs Created Equal