There are multiple Biotechnology ETFs in the market, XBI, IBB and PBE are three of them
Diving deep down to the creation methodology as well as observing holding positions, performance, liquidity and expense fees help do the right pick
Healthcare, especially biotechnology companies are the most lucrative and also most volatile to invest on. ETF provides the best vehicle if you want to get certain exposure to returns from this vertical, and also don’t want to be burned badly.
There are about 7 Biopharmaceutical/Biotech themed ETFs offered in the market, which one should we choose?
A direct and intuitive approach certainly is to look at their performances over a sufficiently long time period. The price plots of the three ETFs – IBB, XBI, PBE- as shown in the following indicate significant difference on their performances – IBB yields more than doubled than PBE, while XBI sits in the middle. The trading volume follows the same pattern.
This drastic difference reminds investors to do the further and deeper due diligence work rather than randomly picking a so-called biotech thematic fund, and be complacent about it. (I should put three charts into one)
So what causes the difference? It boils down to the mechanism or the rules in forming the group of stocks included. Usually, there are two critical parts of the rule that come into play. One is the fundamental definition, and hence picking basis of a particular theme. For example, is it precisely biotech fund, or is it pharmaceutical groups, or it could even be scientific research products, or medical devices firms. The other one is a kick or twist of strategy, which could be smart-beta a.k.a equal weighted schema to mitigate large market capitalization bias, or it could be another layer of ranking based on year-over-year return, ROI, or sales growth, it also could be the futures or forward on the underlying assets or currencies to hedge potential risks.
Let’s take a deep diving into these three ETFs from the above two perspectives.
According to the prospectus, “the Index Provider includes 30 biotechnology and genome stocks from a universe of the 2,000 largest U.S. stocks (by market capitalization) traded on the NYSE, NYSE MKT and the NASDAQ, after having ranked the stocks based on their capital appreciation potential using a proprietary NYSE Arca Intellidex model. The Index Provider splits stocks in the Biotechnology & Genome Group Universe into quintiles based on market capitalization. Larger stocks are defined by inclusion in the top quintile and smaller stocks are the bottom four quintiles. The 8 top-ranked relatively larger stocks collectively receive 40% of the Index weighting (each stock receives on average a 5% weighting) and the 22 top-ranked relatively smaller stocks collectively receive 60% of the Index weighting (each stock receives on average a 2.73% weighting). The Fund generally invests in all of the securities comprising the Index in proportion to their weightings in the Index.”
Now interpret the lines from perspective one, the fundamental selection is anything that is related to biotechnology and genome stocks, to shed more light, Invesco, through the indexer NYSE, referenced FactSet Revere’s patented industry classification system – Hierarchy- to identify these biotech and genome stock. Eyeballing the top listed names – Gilead, BioMarin, Amgen, Incyte…, they are all good match to Biotech. What plays a large role is the other perspective- the kick. Invesco used a vague term here: “capital appreciation potential using a proprietary NYSE Arca Intellidex model”, but I don’t think there is anything really sophisticated besides momentum ranking or sales growth screening. Note they arbitrary pick 8 large stocks from top quintile, then another 22 from bottom quintile, making the composition of the fund mystic to some degree. A small universe of ~30 stocks inevitably introduces or keeps the high-risk profile companying biotech firms, as a result, the performance of PBE is lackluster compared to its more diversified peers. In their annual report, the fund managers pointed out the inclusion of Immunogen drag down the whole performance.
This fund tracks the NASDAQ Biotechnology Index, which only includes NASDAQ listed companies that are classified as biotechnology or pharmaceuticals according to the industry classification. This fund selection methodology is simple and plain – there is no second layer of proprietary ranking to screen out high capital return potential. Instead of attempting to gain outperformance relative to the index, the fund intentionally “eliminate the chance that the Fund will substantially outperform the Underlying Index but also may reduce some of the risks of active”. And this fund doesn’t claim “smart beta”, meaning it is market capitalization weighted. As a result, the fund has certain exposure to pharmaceutical and Life Sciences Tools & Services (as shown in the chart)
There are 191 holding positions as of May 11th, 2016. Following shows the top 10
This fund seeks to track the S&P Biotechnology Select Industry Index, which basically employs the Global Industry Classification Standard (“GICS”) to identify companies on a biotechnology group within its sub-industries. They also layer in another factor such as liquidity threshold is float-adjusted market capitalization being above $500 million, or $400 million if another ratio value exceeds 150%. The eligible equities shall be listed on NYSE, NYSE Arca, MKT, NASDAQ. It’s equal weighted and as of May 10th, 2016, the index comprises 90 stocks:
To conclude, IBB contains the most components – about 200 compared to XBI is 100 or so and PBE is about 30, the more number of companies, the more representative and diversified in this biotech space. Therefore, if the purpose is to get exposure to this biotech sector, especially when you are looking for early-stage investments, I regard IBB the best choice. Even better, the performance of IBB is also far better than XBI and PBE as shown in above three charts: a 5-year return of indices underlying IBB is 21.28% XBI is 17.54%, and PBE is only 11.92%. Let’s also take into consideration of the total expense/fees on these three funds are 0.48%, 0.35%, and 0.66% respectively. Invesco PowerShare almost doubled the fees compared to State Street SPDR. Thirdly, the trading volume, hence the liquidity of IBB is the highest among the three. All in all, IBB seems to be an optimal choice for me.