Try This ETF Pair to Round Out Biotech Exposure

This article was originally published on ETFTrends.com.

If you're using funds, such as IBB and BBH, for biotech exposure in your portfolio, you're mostly investing in the industry's biggest names.

IBB has nearly 30% of its assets invested in the big 4 biotech companies - Gilead, Biogen, Amgen and Celgene.

Equal weighting the biotech sector might be a better way to balance out risk and improve returns.

I propose using a pair of equal-weight biotech ETFs in place of IBB.

This idea was discussed in more depth with members of my private investing community, ETF Focus.

The iShares Nasdaq Biotechnology ETF (IBB) is the largest biotech-focused fund there is. With nearly $10 billion in assets, it is THE proxy for the biotech sector for many investors. But is it the best proxy? IBB does a pretty good job of covering the entire biotech sector.

It's broadly diversified and covers not only the industry's giants, such as Gilead (GILD), but also the tiny companies that are still pushing their lead drugs through clinical trials. My only real quibble with the fund is its market-cap weighting strategy. It's putting a lot of weight into just a few names, and it's cost shareholders over the last few years.

Over the past three years, IBB has returned precisely 0% with some wild swings in returns along the way. The main culprit is the mega-cap biotechs - Gilead (GILD), Biogen (BIIB), Amgen (AMGN) and Celgene (CELG).

Amgen has done pretty well, but the other three have been real anchors. With those four names alone accounting for around 30% of the fund's assets, it's going to be difficult for IBB to make a sustained move up without those names on board.

In the biotech sector, I think equal-weighting is the way to go. In such top heavy sectors, it helps spread out and diversify away some concentration risk, while adding the extra return potential of some of the sector's smaller names.

The obvious alternative to IBB is the SPDR S&P Biotech ETF (XBI), an equal-weighted fund that holds around 100 names, about 90% of which also appear in IBB, but skews much more heavily to small- and mid-cap names. It's performed monumentally better than IBB over just about any time period you look at (XBI has returned 27% over the past three years compared to the -1% return of IBB shown in the chart above). I certainly wouldn't fault anybody for going this route, but there's another strategy I like too.

The Virtus LifeSci Biotech Products ETF (BBP) and the Virtus LifeSci Biotech Clinical Trials ETF (BBC) essentially split the biotech universe into two groups. BBP invests in products stage companies. They have already successfully completed multiple human clinical trials and have received FDA approval to sell and market a drug. BBC invests in clinical trials stage companies.

These companies are typically younger, smaller companies which do not have a drug approved, but instead focus on testing their experimental drug candidates in human clinical trials.

The indexes for both BBP and BBC are sponsored by LifeSci Index Partners, and uses a selection committee to determine which biotech companies qualify for each index. To make the cut, companies need to meet certain size and liquidity requirements, but also need to be considered "pure" biotech companies.

This means they can not fall into one of these nine distinct sub-industries of the biotech sector: Animal Health, Conglomerate, Diversified Healthcare, Healthcare Services, Large Pharmaceuticals, Specialty Pharmaceuticals, Medical Devices, Nutraceuticals, or Tools.

The differences in targeting criteria and market cap minimums mean that XBI and the BBP/BBC pair are not entirely similar. Currently, 78% of XBI's components appear in either BBP or BBC.

BBP and BBC have both been around since the end of 2014, so we have 3+ years of overlapping risk/return data to work with to compare each of the funds.

The 2015-2017 time frame was especially volatile for biotechs, with the standard deviation of daily returns more than doubling that of the S&P 500. XBI, for example, was up nearly 50% during the first seven months of 2015, before plunging nearly 50% from its 2015 highs by the beginning of 2016. Putting the four biotech ETFs side by side, it becomes clearer where the returns and the risk have been coming from.

The 13% average annual return of XBI and the 2% average annual return of IBB show how the biggest biotechs have been dragging down returns.

The standard deviation of returns and max drawdown suggest that IBB has been the least volatile ETF during that time frame, but a Sharpe ratio of 0.2 also tells us it's done with worst job of delivering risk-adjusted returns. The Sortino ratio, a measure of excess returns compared to downside risk, is also the worst of the bunch.

We can also see that the more mature biotechs have outperformed the more speculative clinical trial stage biotechs. That's not necessarily surprising given that the market hasn't been rewarding excess risk with excess returns (beta ETFs, such as the S&P 500 (SPY) have been outperforming both smart beta and high beta products as a whole). BBC has underperformed BBP by more than 10% annually, while experiencing a far higher degree of volatility.

As mentioned earlier, I prefer an equal-weighted biotech ETF over a market cap-weighted one, because, even though it's historically come with about 25% higher risk, it's also produced around 30% greater returns, resulting in higher risk-adjusted returns. Plus, the equal-weighted product makes you less reliant on the performance of just a few big names.

The reason I like the BBP/BBC pair is the flexibility it gives in adjusting your biotech exposure as you see fit. XBI maintains a steady allocation to the entire biotech sector, and since it rebalances itself every quarter, it's never going to stray too far from its current balance of product stage/clinical trial stage companies. Using BBP and BBC allows you to tilt your portfolio based on current conditions within the sector.

Conclusion

For the record, I think XBI is a good option for biotech investors. Its expense ratio of just 0.35% is the cheapest in the space and less than half that of the 0.79% expense ratios of BBP and BBC. So I don't think there's anything wrong with using XBI.

More frequent traders and those who study the biotech sector more closely may appreciate the flexibility of overweighting specific types of companies within the sector depending on their own research. In that case, using BBP and BBC in lieu of a product, such as XBI, makes sense. Whichever option you choose, I think both make more sense than going with IBB.

This article has been republished with permission by Dave Dierking.