The handful of biotech ETFs have more differences than they do similarities.
Biotech ETFs have become a popular tool for investors looking to enhance return opportunities through a tactical allocation within their portfolio, thanks in large part to a blistering track record. Biotech ETFs can be found near the top of most performance leaderboards over both five-year and 10-year time horizons, having outperformed broad-based funds by a wide margin in recent years.
Since iShares introduced its Nasdaq Biotechnology ETF (IBB) in 2001, several other products have followed suit; there are now nine biotech ETFs that have aggregate assets of more than $15 billion, though IBB accounts for more than half of that total.
When determining the best ETF for a core asset class such as domestic stocks or bonds, the primary considerations tend to be toward expenses. But investors seeking to make an allocation to the biotech sector have more on their minds than simply Boglehead principles; they’re looking to take on some exposure to a risky sector in exchange for the potential to enhance long-term returns. As such, other characteristics should take center stage in a comparison of the ETF options.
Biotech Industry in Focus
Biotech ETFs typically hold only a fraction of the companies that are included in that sector. There are nearly 170 biotech stocks in the Russell 3000, and dozens of others engaged in other advanced medical technologies such as neuromodulation and in vitro diagnostics. Most biotech ETFs hold only a small portion of this universe.
From the list above, IBB and XBI jump out as the deepest portfolios of biotech stocks. These two can be differentiated primarily through the composition of the underlying portfolios.
While there are some large-cap biotech stocks such as Amgen (AMGN, $117 billion market cap) and Gilead Sciences (GILD, $154 billion market cap) that have somewhat stable cash flows, most of the companies in this industry are smaller and more speculative in nature. Many have promising products in developments, but haven’t yet generated substantial revenues and certainly aren’t profitable. Less than 20 percent of biotech companies report positive EBITDA margins.
In other words, many biotech stocks can be viewed as lottery tickets. A few of them will make important medical breakthroughs, and see their valuations grow many times over. Many of them will fail to generate positive cash flows and will eventually be delisted (and worthless to investors).
IBB is linked to a market capitalization-weighted index, which means that its portfolio is tilted toward the largest companies (such as AMGN and GILD). XBI’s underlying index is equal weighted, which results in a weighting of about 1 percent to each stock regardless of its size. So the IBB portfolio consists primarily of shares in the larger and more stable biotech companies, whereas XBI has a greater allocation to the “lottery ticket” segment of the biotech industry.
In other words, XBI probably has greater risk and greater potential for reward. IBB still makes allocations to the riskier biotech companies, but the weighting is minor in many cases. (The smallest 25 components of IBB combine to make up just 1 percent of the portfolio.)
Investors looking to maximize exposure to the smaller, more speculative biotech stocks will find XBI to be a better choice. Those looking to bet on “big biotech” should select IBB.
Specialized Biotech ETFs
While IBB and XBI cast a relatively wide net within the biotech industry, there are a handful of ETFs that offer even more granular exposure.
- BioShares Biotechnology Clinical Trials (BBC): This ETF focuses on companies that have drugs in the human clinical trials stage of the approval process.
- BioShares Biotechnology Products (BBP): This ETF holds companies that have progressed past the clinical trials milestone, and have received FDA approval for certain drugs.
- ALPS Medical Breakthrough ETF (SBIO): This ETF focuses on companies worth less than $5 billion, with enough cash to last at least 24 months, and with at least one product in Phase II or Phase III of FDA clinical trials.
- ARK Genomic Revolution Multi-Sector ETF (ARKG): This ETF holds companies seeking to extend or enhance the quality of life through fields such as molecular diagnostics, stem cell procedures, bionic medicine, bioinformatics, and bioinspired computing.
For those with a very specific investment thesis, these products may have some appeal; otherwise, IBB and XBI represent effective options for broad biotech exposure with different risk profiles.
About the Author: Michael Johnston
Michael Johnston is senior analyst for ETF Reference, and also serves as COO of parent company Poseidon Financial. His investment expertise has been featured in The Wall Street Journal, Barron’s, and USA Today, among other publications. He resides in Chicago.