How To Play Biotech With ETFs

February 18, 2011

Biotech is looking interesting again; here’s how to play it.

 

I have always loved biotech. I got my start in this industry as a biotech analyst for an actively managed mutual fund, and spent a number of fun years working at Genzyme, one of the largest biotech companies in the world.

For the past few years, however, watching biotech has been like watching paint dry. The broad-based iShares Nasdaq Biotech ETF (NYSEArca: IBB) is trading exactly flat over the past 10 years. That’s astonishing, considering how the biotech industry has evolved. In 2001, the biotech industry was full of hopes and dreams; companies with no revenues but big opportunities. Today it’s full of hugely profitable and fast-growing companies like Celgene, which expects revenue to grow from $3.6 billion to more than $5 billion over the next year.

Biotech also has badly lagged U.S. equities since the market bottom on March 9,2009, with IBB rising “just” 62 percent against a rise of more than 100 percent for the S&P 500.

Yesterday, however, my former employer Genzyme inked a $20 billion buyout deal with Sanofi-Aventis, sparking renewed interest in the sector. Many analysts expect more pharma/biotech mergers in the future. Other eternal optimists (like me) expect biotech growth to surprise on the upside generally in the coming years, as early insights into genomics finally start turning into products.

There are five choices for ETFs in the biotech space, and they vary widely. Choosing the right one will have a big impact on overall returns.

How To Play Biotech With ETFs

Let’s review.

Choice 1: iShares Nasdaq Biotech ETF (NYSEArca: IBB): IBB is the oldest and largest biotech ETFs. It was first-to-market, has the best liquidity and, with $1.3 billion under management, is by far the biggest.

IBB tracks a market-cap-weighted measure of the biotech sector, meaning it puts the bulk of its assets into the largest, most established biotech companies. For example, it has a 7.4 percent position in Amgen.

This is important because the biotech industry is bifurcated. There are a dozen or so large, well-established and hugely profitable biotech companies, like Amgen, Gilead, Genzyme and Celgene, that dominate market-cap-weighted indexes like the one IBB tracks. These companies are best thought of as biotech/pharma hybrids: They share some of the excitement of early-stage biotech start-ups, but also some of the challenges of the pharmaceutical industry, including slow-growing older products, the need to reinvigorate development pipelines, etc. The other half of the industry is composed of earlier-stage start-ups—generally smaller companies with more promise than profits.

IBB’s focus on large-cap stocks should make it more stable than other funds. In addition, large companies like Genzyme are attractive acquisition candidates right now, as they are large enough to move the needle in terms of revenue and profit for major pharmaceutical companies.

If the bio/pharma merger parade really starts moving, IBB could be a good choice.

Choice 2: SPDR S&P Biotech ETF (NYSEArca: XBI): XBI is the second-most-popular biotech ETF, with $428 million in assets under management. XBI tracks an equal-weighted index of 30 biotech companies. That means it puts an equal amount of money into a $50 billion giant like Amgen (AMGN) as it does into an $800 million small-cap like Acorda Therapeutics (ACOR).

This has the effect of de-emphasizing the biopharmaceutical giants in favor of earlier-stage, riskier small-caps. That means added risk, and potentially added rewards, although less exposure to massive biotech buyouts like Genzyme.

 

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