Finding The Best Biotech ETF

It's easy to be blinded by headline numbers. The rally in biotech isn't so simple.

It's easy to be blinded by headline numbers. The rally in biotech isn't so simple.

With the Ebola crisis on everyone's minds, a lot of folks have been writing rather hyperbolic headlines like "Ebola Economics." And it's easy to understand why. While the broad health care sector isn't strictly the highest-performing large-cap sector in the U.S., it's darn close.

Here's how I'd tally up the broad sector returns for the year so far (through Oct. 28, 2014):

Health care's not tops, but like I said, pretty close, and a lot of those gains have come just in the last two weeks.

But unfortunately, health care is the single-most-classic case of ETFs not being equal, so much so that I regularly use a performance chart of health care ETFs to illustrate how important digging into what the "Fit" score in an ETF is.

Consider why XLV is up. It's not the 7 percent position in Pfizer (down 2.7 percent this year) or the holdings of Express Scripts (2.3 percent of the portfolio, up 4.33 percent) that are making it a contender. It's Gilead, up 50 percent so far this year, and Allergan (up 64 percent) and Amgen (up 32 percent).

In other words, the story in "health care" isn't about "health care" at all—it's about biotech—companies out there on the bleeding edge of medical science. And biotech ETFs have had a wild, wild ride this year:

The "loser" in this group, the Market Vectors Biotech ETF (BBH | A-28), is up almost 28 percent. Hardly something to sneeze at. But the reason it's not shooting the lights out is extremely predictable.

Because it's market-cap-weighted, it's heavily loaded up on Gilead, Amgen and Celgene—all enormous companies with diversified revenue streams. And that's great—they're all up a ton. But it means the fund can't take advantage of big surprises in smaller companies.

That's where the First Trust Biotech ETF (FBT | B-25), a perennial performance winner in the biotech race, comes in.

Riding Smaller Biotech

FBT is one of the few funds you'll find in our system that regularly throws off alpha versus our market- cap-weighted segment benchmark. The reason is simple: It's based on the equal-weighted NYSE Arca Biotech Index. That means it makes big bets on smaller companies like Exact Sciences Corp., which is up more than 113 percent this year, despite having never turned a profit.

Those gains come on the back of its potential, not because of its current income statement (Exact Sciences is making at-home cancer screening tests, and has gotten some phenomenal press this year).

But here's the thing: These biotech bets can be enormously risky. Take a look at how these ETFs performed when things got sour in March this year:

While FBT didn't perform as badly as some others in the list, they all retreated very quickly.

Wild Rides Assured

Biotech, perhaps more than any other sector, is incredibly "swingy," and subject to news flow contagion. One firm in the space can get good news, and that can get investors buying up everything remotely related.

One drug can fail a Food & Drug Administration trial, and the whole sector can sell off as investors head for the door.

The moral of the story here? The more narrow the investment thesis, the more you have to look under the hood. We've had FBT flagged as an "opportunity pick" since we instituted those little light bulbs on the fund pages.

At the time this article was written, the author held no positions in the securities mentioned (and he knows biotech—ETF.com President Matt Hougan once lost him a lot of money when he was a biotech analyst at the author's mutual fund). You can reach Dave Nadig at [email protected] or on Twitter @DaveNadig.