Why Biotech ETFs Can Be a Great Choice for Risk-Averse Investors

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Exchange-traded funds (ETFs) that focus on the biotechnology sector have been around for more than a decade and a few of them have been stellar long-term investments. That can make them a good option for investors who want more exposure to the biotech industry without the hassle of picking their own stocks.

In this segment from Industry Focus: Healthcare, host Shannon Jones and Fool.com contributor Brian Feroldi discuss the pros and cons of using ETFs and highlight why the Nasdaq Biotechnology ETF (IBB 1.51%) and SPDR S&P Biotech ETF (XBI 1.12%) are worth a closer look.

A full transcript follows the video.

This video was recorded on Jan. 23, 2019.

Shannon Jones: The odds are definitely stacked against the average biopharma company. But let's talk about us as average Joe investors, Brian. For people like you and me who want to play in the biotech space, but don't necessarily want to take on all of that risk by investing and chasing some of these one-hit wonder biotech companies, what's a good way to actually jump into it that's also safe?

Brian Feroldi: There are a couple of strategies that individual investors could take to lower their individual risk. The first and probably the easiest for them to do is to get their biotech exposure by using exchange-traded funds, more commonly known as ETFs. These are funds that individual investors can buy, and when they do so, they can gain instant access to dozens or even hundreds of individual biotech stocks. What that does is, it spreads their money out across dozens or hundreds of holdings, basically in an instant. That greatly increases the odds that those few huge winners that will emerge in the biotech sector will be in your portfolio.

Jones: With ETFs, you're getting a basket of securities. You can buy and sell them through your brokerage, much like an individual stock. It gives you the flexibility and also helps minimize some of the risk. Brian, you've got two ETFs, two that we actually talk about a lot on Industry Focus, especially when we're benchmarking returns for a particular company, or even just trying to gauge investor sentiment and how people are feeling about biotech. Let's start with the first one, the Nasdaq Biotech ETF, also known as the IBB.

Feroldi: This is the biggest and the most popular ETF that's focused on biotechnology on the market. It holds more than 200 companies in it. It actually has a focus on the biggest stocks in biotechnology -- Biogen, Celgene, Amgen, and Gilead are the four biggest ones, and this fund has a heavy concentration in the big names. Because of that concentration, it actually comes with a dividend yield of 0.2%. Admittedly, that isn't much. But, considering you're talking about the biotechnology industry, it's actually pretty remarkable.

Even though it has a concentration on the biggest names, this is a fund that has performed very well for investors. Over the last decade, the IBB is up 370%. For comparison, the S&P 500 is up 286%. This a single fund that has a decade-long history of outperforming.

Jones: Just to give our listeners some idea in terms of exposure, you've got, of course, the big biotechs that you mentioned -- Biogen, Celgene, Amgen, and Gilead -- but you've also got exposure to pharmaceuticals. Just looking at the fund itself as of today, in terms of exposure, you've got 80% in biotech, you've got about 9% in pharmaceuticals, and looks like about 8% in the life sciences, tools, and services. So, in terms of spreading out that exposure across multiple sectors, in terms of diversification, this one is probably the most popular for that reason.

Let's turn our attention, because the other ETF that you mentioned is one that is not as widespread, but for those that are looking for more concentrated biotech exposure, this could actually be one that is a good idea to invest in. It's the SPDR S&P Biotech ETF, also known as the XBI.

Feroldi: This is a fund that I personally happen to like a lot. Like the IBB, it's spread out. This one has 120 individual holdings in it. It's very well-diversified. However, what differentiates this fund is that it takes an equal-weight approach to its indexing, as opposed to the Nasdaq Biotech ETF, which takes a market-weight. What that means is, the 120 holdings that are in this fund, the percentage of the fund that is in each individual holding is exactly the same across the board. And this rebalances itself. What that does is gives stockholders much more exposure to the small stocks. A couple of them that are in there, for example, are Portola Pharmaceuticals, Neurocrine Biosciences, bluebird bio. You have the exact same exposure to those small ones as you would to the larger ones. If you're the type of investor that's looking for a little bit more upside potential and you want to have a bigger concentration in the small stocks, which can put up huge percentage gains if they work out, the XPI gives you a little bit more exposure to that.

Jones: For the brand-new investor, Brian, who's thinking, "This sounds like a very compelling investment opportunity," what's the downside? What am I not getting when I invest in ETFs that I could be getting from stocks?

Feroldi: Like anything, you do give up a little something when you invest in ETFs. With ETFs in particular, you do have an expense ratio that you have to pay that you wouldn't have to pay if you owned individual stocks. To put some numbers on that, the IBB has an expense ratio of 0.47%. The XPI is a little bit lower at 0.35%. So, you have a small fee that you have to hold these exchange-traded funds over the course of a year. I think that's a pretty modest thing that you have to give up in exchange for the broad exposure.

The bigger disadvantage is that diversification cuts both ways. Because you're owning so many stocks, you're guaranteed to hold a lot of companies that are probably going to lose, and they're going to lose badly. Whereas if you were picking individual stocks, and you were really good at it, you might be able to get a higher concentration of the winners. You're trading risk, in this case, for that reward. And because these funds have both done so well over the last decade, they've both outperformed the S&P 500, I think that's a trade-off that's worth making.