Biotech ETFs: Outstanding Risk-Adjusted Portfolios

| About: iShares Nasdaq (IBB)
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How do you make an investor smile? Tell him his portfolio is up even more than the broad market, as measured by the S&P 500 or the SPDR S&P 500 ETF (NYSEARCA:SPY). How do you make her smile even more? Tell her she achieved this performance with a portfolio which is less risky than the overall market!

Seeking Alpha readers should be no strangers to BETA, the measure of risk which measures the sensitivity of portfolio returns to that of the overall market. Somewhat crudely, if the SPY gained 10% and your holdings increased 15%, your portfolio has a beta of 1.5. If your holdings only increased in value by 8% in this same period, your portfolio has a beta of 0.8. The actual calculation is done using a procedure known as linear regression; but for our purposes, this simplified example is adequate.

As I made clear in this article, the Betas of diversified portfolios are quite stable over time. As a result, you can use the Beta of your portfolio to gauge its expected performance over a given time span. A sample calculation makes this clear. Imagine the SPY gained 9% in the last five months, and your portfolio or ETF had a beta of 1.2. Then you should expect your holdings to increase by 10.8% over this five month span:

(S&P 500 return) * (portfolio beta) = (expected return)

(9.0%) * (1.2) = 10.8% expected gain

Most investors and analysts talk about some sectors "outperforming" or "underperforming" the market, all the time. Unless these returns are adjusted for the risk of the portfolio, these analyses are incomplete and deceptive. As I demonstrated in the article I referred to above, many folks claim Utilities, as measured by the SPDR Utilities ETF (NYSEARCA:XLU) underperformed the market this summer. But if you adjust for the lower risk XLU has, Utilities performed exactly as you would expect them to.

I thought I would turn this analytical focus on one of the economy's most promising and innovative sectors, biotechnology. There are numerous Biotech ETFs, but only three were large enough and liquid enough for the statistical procedure above to be meaningful.

ETF Assets Vol # Holdings 3 Year Beta 5 Year Beta 10 year beta
IBB 4 B 711 125 .8 .72 .71
XBI 1 B 282 57 1.11 .80 ------
FBT .8 B 208 20 1.08 .92 ------


At first glance, my premise that betas are stable for diversified portfolios seems erroneous. The betas for the SPDR Biotech ETF (NYSEARCA:XBI) and the First Trust NYSE Arca Biotech Fund (NYSEARCA:FBT) have changed quite a bit. However, look at the iShares NASDAQ Biotechnology (NASDAQ:IBB). This is the largest fund, by portfolio size; it is the most diversified, having the largest number of holdings; and it is the most liquid, trading the most shares weekly. All these factors contribute to the stability of Beta. Furthermore, IBB has ten years of data. You will also notice that betas for XBI and FBT have been trending downward, and are now much closer to IBB's beta than they were before.

I will therefore look at IBB as the best gauge of Biotech industry performance. How has it done, on a risk adjusted basis, compared to the broad market as measured by SPY?

In a word, impressive. Since the summer rally kicked in on June 24th, the market has rallied about eight and half percent. Since IBB has a beta of only .71, we would expect the portfolio to have a gain of:

(beta) * (S&P500) = expected IBB performance

(.71) * (8.5) = 6.035 or six percent, roughly.

A glance at the chart below shows just how impressive IBB has been in the last three months:

Achieving a return of twenty five percent when you expected only six sure will bring a smile to a stockholder's mug! This shows just how well the biotechnology sector has performed recently, amidst breathtaking advances such as this.

One final comment I wish to add. Some readers may not understand how a portfolio of very volatile stocks (as biotechs surely are) can have such low risk, or low beta. Remember that beta measures how the shares move relative to the market. Biotech stocks often appear to be in their own separate universe (Carl Sagan would be proud), moving helter-skelter amidst FDA approvals, joint ventures, etc. However, these zigs and zags often have little to do with broader market trends and currents. Thus, a small investment in Biotechs such as IBB will reduce, not increase, the overall risk of your portfolio. And improve your performance. Worth smiling about, indeed.

Disclosure: I am long XLV, IHI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.