Hidden Gem ETFs

December 01, 2017

ALPS Medical Breakthroughs ETF

Biotech is one of the hottest themes on the planet. All the long-heralded promise of the genomics revolution seems to be bearing fruit, with incredible breakthroughs coming at a furious pace. But the biotech sector has changed. What was once a niche market dominated by small-cap companies looking to cure the world has become a top-heavy market dominated by firms generating billions of dollars in revenue.

SBIO lets you refocus your biotech hopes and dreams on the pointy edge of the spear. By focusing on small- and midcap names with at least one drug in phase ii or phase iii clinical trials, it hits directly at the heart of biotech r&d. It’s the exciting part of biotech, and it’s worth a look.

Matt Hougan, CEO, Inside ETFs: What drove you to develop SBIO?
Mike Akins, Head of ETFs, ALPS: Obviously, biotech is an attractive space. But more importantly, we felt there was an opportunity to differentiate SBIO from competing funds given the disruption we are seeing in the space.

Today the bulk of the R&D being done in biotech is being done by smaller companies, while larger companies have evolved into distribution- driven, pharmaceutical-like firms. Those larger companies are replacing their drug lineups by using capital to either do joint ventures or buy smaller companies.

How does your methodology differ from a more traditional, market- cap-weighted biotech ETF?
Really it does so in three ways. The first is size. We look at companies only in the $200 million to $5 billion market-cap range. It’s still a large, liquid space—it captures about 250 companies and $200 billion of market capitalization—but it helps us focus on R&D-led companies.

The second piece is where we’ve partnered with S-Network and Poliwogg Indexes. Poliwogg is a financial technology firm developing unique investment products in the health care/biotech/life sciences sectors.

We were able to utilize their expertise to create a unique screen that only focuses on companies that have at least one drug in Phase II or Phase III of the clinical trial process. Phase II and Phase III drugs have a much higher success rate than preclinical or Phase I drugs. The screen lets us focus on companies that have made some progress in getting a drug to market.

Finally, what gives us a higher success rate than the overall market is the cash overlay. We insist that companies have at least two years of cash on the balance sheet at their current burn rate.

In the end, you get companies that are the right size to be working on real R&D; that have proven they can get past at least Phase I of the clinical trial process; and that have enough cash to where you think they will be able to see the process through.

A lot of people think of biotech as small startup companies. What kind of companies are you excluding with your size screen?
The largest ETF in biotech follows the Nasdaq Biotech Index, which is a straight market-cap-weighted biotech index. It has companies in the $200 million to $300 billion market-cap range.

There is great opportunity in larger companies, but we wanted to capture the R&D side of the equation, and create a product that can add value in the portfolio construction process. We often work with RIAs who blend our product with something like the Nasdaq Biotech Index. While that index allocates 55% of its weight to names already held in XLV, the Health Care Select Sector SPDR Fund, SBIO currently has zero names in common.

How has performance been?
Performance has been strong on an absolute and relative basis since inception, but it has also been volatile. In 2015, we were the No. 1 performer in biotech by a long shot. In 2016, with changes in the political environment, we went down more than the large-cap-focused indexes. In 2017, with political head winds related to drug pricing taking a back seat to more stock specific stories, we’re having another very strong year. We are highly correlated with the sector overall, of course. We’ve been coming in with a beta of 1.3-1.4 to the biotech sector as a whole.

When will this strategy beat a market- cap-weighted biotech index?
It’s going to perform best when you see a focus on the micro and not the macro. It also does very well when M&A activity picks up. In 2016, approximately 15% of our portfolio was acquired.

Do you expect that M&A activity to continue?
We do. We actually think one of the big potential catalysts for this portfolio would be some sort of tax reform that includes the repatriation of foreign cash. A lot of the big biotech companies have some of the largest amounts of cash sitting overseas. Bringing that back stateside would be a big potential catalyst for increased M&A activity.

What’s the expense ratio, and how did you price it?
We looked at the median average of biotech ETFs and priced ours slightly below that, at 0.50%.

Importantly, though, we look at SBIO as a stock replacement story. Biotech as a whole has proven to be a very difficult place to pick securities. It’s tough to determine who will be first to market with a given drug. And critically, the distribution of returns in biotech is tail-oriented: You have a lot of companies that will go bankrupt and a lot of companies that will be two-baggers, four-baggers or even 10-baggers. You don’t have a lot in the middle. So picking any one stock in the space is very risky. SBIO provides a diversified alternative at a reasonable fee.

If you had to sum up SBIO in one sentence, what would you say?
It’s a stock replacement story that provides investors the ability to add alpha through a very promising theme.

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