The challenge for many investors who are trying to diversify their portfolios is finding sectors or asset classes that don't move in tandem together. One sector that has moved up-even as many equity indexes have fallen-is biotech.Performance: Behind the Numbers
Over the past three months, even as the S&P 500 and other broad market indexes have generally suffered (the S&P 500 is down 0.62% to date) biotech stocks have generated impressive returns. The iShares Nasdaq Biotechnology Index Fund (IBB) is up almost 12.7% over this period, and the Folio Investing Biotechnology Folio is up 22% over this same 3-month period. For the trailing 12-months, the Biotechnology Folio is up 40% and IBB is up 23.8% compared to the S&P 500 which is up only 5.2%.Industry Overview: A High-Risk, High-Return Sector
The biotech sector has a number of unique attributes. First, biotech firms spend a far larger portion of their resources on Research and Development (R&D) than most industries. In fact, over the past 25 years, the average R&D spending for biotech firms is 38% of the value of all of their assets (this is referred to as R&D intensity). By contrast, the average R&D intensity across all U.S. industries over this period was only 3%. Second, the success or failure of biotech firms depends heavily on having new drugs and therapies move from initial testing all the way through to final human trials. The profitability of these firms can also be highly sensitive to changes in regulatory policy.Commentary: Why Biotech Stocks Defy the Broader Market
In general, biotech stocks have a relatively low correlation to the broader stock market. Over the past three years (through May 2012), the Biotechnology Folio returns have a 70% correlation to the S&P 500, while IBB's returns have a 77% correlation. Also, biotech stocks tend to be more volatile than the broader market. For example, the Biotechnology Folio has trailing 3-year volatility that is 33% higher than the S&P 500. IBB's trailing 3-year volatility is 12% higher than that of the S&P 500.
Also, Biotech stocks represent a high risk/high return value proposition. The biotech sector can go through extended periods of outperformance versus a broad equity index (and vice versa). The relatively low correlations in returns between this sector and the broader market suggest that this is a consistent feature of this sector. There are a range of factors that drive the biotech industry (noted above) that are distinct from those that drive the stock market as a whole.
The unique attributes of this sector clearly provide the potential for substantial returns, even when the broader stock market is not performing well. Along with the potential for higher returns, however, investors who choose to concentrate their assets in this sector, need to understand the unique risks and potential for high volatility.The Top 5 Holdings in the Biotechnology Folio
The Biotechnology Folio was developed for investors seeking aggressive capital growth with significant volatility. The top 5 holdings include:
- Acorda Therapeutics Inc. (ACOR)
- Alkermes Plc (ALKS)
- Alexion Pharmaceuticals Inc. (ALXN)
- Amgen Inc. (AMGN)
- Amylin Pharmaceuticals Inc. (AMLN)
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