Taking a Chance on Biotech

04/22/2010 11:55 am EST

Focus: ETFS

Scott Burns

Director of ETF Analysis, Morningstar, Inc.

Scott Burns, Morningstar’s director of ETF analysis, and analyst John Gabriel like a biotech ETF that gives more weight to companies with potential breakthrough drugs.

We think that investing in biotechs via an exchange traded fund makes a ton of sense thanks to their boom-bust nature. First Trust NYSE Arca Biotechnology Index (NYSEArca: FBT) represents an interesting way for investors to gain exposure to the promising but volatile biotech industry. Because of its narrow focus, the fund should be treated as a specialty satellite holding.

The index has only a handful of established biotechs, and almost half are early stage players with no drug on the market yet. Would-be investors should note that, because the index gives an equal weighting to all of its stocks, these smaller firms, with decidedly uncertain prospects—and explosive upside potential—loom larger. Over the past three years, the fund has been 63% correlated with the Standard & Poor’s 500 Index and 82% correlated with the broader health-care sector.

The chances of a biotech getting a blockbuster drug through clinical trials and onto the market have been likened to those of going to Hollywood and becoming a star. Industry experts estimate that one in five therapies, at most, will survive the ten- to 15-year development and clinical gauntlet required to get regulatory approval. With the process costing $1 billion, on average, many biotechs surrender their drugs’ marketing rights to big drug firms in exchange for cash upon reaching various development milestones.

Of course, with that risk and volatility comes great opportunity. Firms that develop innovative therapies and successfully get their products to market stand to reap bountiful rewards. Merger activity has also heated up in the industry, providing another potential catalyst. With a blitz of generic competition on the horizon, many are speculating that Big Pharma, with its cash war chests, may be on the prowl.

In our view, the biotech industry is less susceptible to government intervention than are other health-care subsectors. In any case, we think an ETF is the appropriate tool for investing in this notoriously volatile subsector.

To be sure, one drug’s odds of success are typically unrelated to another’s; we like the diversification among individual firms this fund offers, which helps diffuse single-stock risk.

The ETF tracks the NYSE Arca Biotechnology Index, an equal-weighted index of 20 US-based biotech companies. Because there are just a handful of established biotech companies, the sector is mainly made up of small- and mid-cap stocks. The index’s equal-weighting scheme accentuates this, as upstarts sit shoulder to shoulder with established players such as Amgen (Nasdaq: AMGN). As of March 2010, the portfolio’s holdings-weighted average market capitalization was approximately $4 billion.

The fund’s 0.6% net annual expense ratio is a bit pricey relative to rival fund SPDR S&P Biotech (NYSEArca: XBI), which charges 0.35%. That said, FBT’s annualized three-year return of 16% through March 2010 easily beats the 8% return posted by XBI. (FBT closed Wednesday around $36.50—Editor.) 

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