Nadig: Biotech—And IBB—Doing Just Fine

Panic attack about the sector is overblown.

To read the headlines, you’d think we were on the verge of some kind of biotech apocalypse. Nothing could be further from the truth—at least as far as the ETF functioning goes.

I understand the desire for hyperbolic headlines. After all, I once wrote a blog post titled “The Worst Index In The World.” But the handwringing going on about biotech ETFs, and the iShares Biotech ETF (IBB | A-46), because of flows and shorting data, is just supremely misguided. So what’s really going on in biotech-land, and is IBB doing what it’s supposed to do?

First, let’s start with a chart (all charts came from Bloomberg this morning):

This is the price of IBB over the last year, with the shares outstanding mapped over it. Notice just a touch of similarity between the two lines? This should come as a surprise to exactly nobody who understands how ETFs work.

Shares of an ETF are created by an authorized participant when the price in the open market exceeds fair value. When is that likely to happen? When there are a lot of buyers for the ETF. When there are lots of buyers, prices go up. For a stalwart ETF like IBB, which is 10 years old and with almost $5 billion in assets, it essentially is the biotech market as far as a lot of traders are concerned. And with a hedge-fund-friendly handle of more than $200, it’s the trader’s choice.

So even before I pulled the chart, I would have been frankly shocked if I didn’t see shares outstanding rocketing in January and February, and plummeting in recent weeks. Indeed, that’s precisely what’s happened.

But let’s look a little deeper.

Here we’re looking at the realized premium and discount based on closing prices in IBB so far this year (the center line). The bottom of the chart shows creation and redemption activity in dollars; the top chart just shows price.

First, note the time lag. That big notable redemption from three days ago? It’s actually the result of trading on the day prior. It gets reported to the National Securities Clearinghouse Corp. with a one-day lag. And lo and behold, the redemption happened on a day when the fund traded to a near-20 basis point discount. As premiums and discounts go, that’s pretty tiny. Most funds trade at spreads nearly that wide. In the case of IBB, with its enormous $200 handle, that 20 basis point premium actually represents something on the order of 50 cents of “mispricing,” which was clearly enough for the APs to book the arbitrage by redeeming IBB shares and selling the underlying biotech stocks.

The 20 basis points discount here is entirely in range, and frankly, has essentially no impact on most investors unless you happen to be panic selling at exactly the wrong time. After all, would you be overly concerned if you saw the iShares Gold Trust (IAU | A-99) trading off a penny or two? That’s what the equivalent would be on its $12 handle.

What’s happening here is exactly what’s supposed to happen. Importantly, I didn’t read too many headlines this morning about the fact that over the last two days, nearly all of the “record outflow” from three days ago has come right back into the fund.

The last bit of hyperbole around biotech and IBB in particular seems to be about short interest. It is in fact the case that as of the last report, plenty of folks wanted to short IBB:

Short-interest data is notoriously buggy, and it’s lagged. The last report we have is as of March 14, and you can see that in fact short interest (the middle line) was up to about 7 million shares. That recent high coincided, entirely predictably, with the top of the run in biotech stocks. It’s also worth noting that while the number of shares is relatively high for the year, it’s actually a lot less of trading volume than it was, say, in December.

The risk of a “squeeze” was much higher back then, because there wasn’t anywhere near the daily volume in the ETF itself.

So what are we to make of this? We’ll get the new short report any day now, and I’m willing to bet we’ll see that number coming down a little. In this case, the shorts were right, and they caught the fall in biotech nicely. The smart money likely covered their shorts at the end of March, and biotech can now go on about its merry way, waiting for the next round of Food & Drug Administration approvals.

What’s the moral of the story here? Be careful of reading too much into lagged, buggy data like short reports and daily asset flows. Nine times out of 10, all they’re really showing you is that the system is doing exactly what it’s supposed to be doing.

At the time this article was written, the author held no positions in the securities mentioned. Contact Dave Nadig at [email protected].