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Biotech stocks are not for the faint of heart.
The majority of publicly traded biotechs are not yet profitable, which leads investors to value them by guessing about the future revenue potential of their pipeline based on how well drugs perform in clinical trails. Breaking news can lead to wild price swings, both good and bad, which scares away many investors from the sector. While I understand the trepidation, I think it's a mistake to simply ignore investing in biotech completely, as winning biotech stock returns can be extraordinary.
So how can risk-averse investors add biotech exposure to their portfolio without having to take individual company risk? One easy way is to buy into an exchange-traded fund, or ETF, that owns a huge basket of biotech stocks. One such ETF that might be worthy of consideration is the SPDR S&P Biotech ETF (NYSEARCA:XBI).
Investors in this ETF have enjoyed a terrific long-term ride, as the returns since it first launched in 2006 have simply crushed the S&P 500. The annualized return since hitting the markets is currently a blistering 19.27%.
Of course, just because an ETF (or mutual fund, or stock) has performed well in the past doesn't necessarily mean it will perform as great going forward. To get a sense of what investors can expect from this ETF in the future, it's helpful to crack it open to how the fund operates.
Currently, this fund holds 103 companies, which immediately offers investors great diversification. What's particularly interesting to me is that this fund uses an "equal-weight" strategy for sizing its investments. An equal-weight strategy simply means that all of the companies held in the fund are given the same initial weighting, regardless of the size of the company. Most other stock market indexes use a "weighted average market capitalization" system, in which more of the fund's money is invested in larger companies and less in smaller ones.
While I tend to like ETFs that use equal weighing, it's important for investors to understand that smaller-cap companies tend to be a bit more volatile, and that's especially true of biotech stocks, which means this ETF might be more prone to even more volatility than a weighted-average ETF would be.
| Quick stats: | |
| Category | Specialty health |
| Expense ratio | 0.35% |
| Yield | 0.68% |
| Total assets | $2.61 billion |
| Morningstar rating | 4 stars |
| Price/prospective earnings | 30 |
| Turnover ratio | 86% |
Source: Morningstar.
A few numbers jump out at me. With an expense ratio of just 0.35%, this fund is a cheap way for investors to gain immediate diversification in the biotech sector. However, it also has a high turnover ratio of 86%, which means the fund is regularly adding and subtracting stocks, which can lead to higher taxes for shareholders -- though given the incredible performance of the fund, I doubt this has bothered most investors.
Another number to watch is that very high price-to-prospective earnings ratio of 30, which is far higher than the S&P 500's 19. However, seeing a high number shouldn't be all that surprising, especially since almost half of the companies the biotech fund holds don't even have a drug on the market yet, so profits could be a long ways away -- and this is just the nature of the industry.
Going small
This fund is concentrated in the smaller side of the biotech spectrum:
| Size | % of Portfolio |
|---|---|
| Giant | 3.19 |
| Large | 6.46 |
| Medium | 19.57 |
| Small | 36.01 |
| Micro | 34.76 |
Source: Morningstar
The vast majority of assets are in the medium-, small- and micro-cap spectrum of biotech. So far, this strategy has produced some stellar returns, and the broad exposure of the fund should give some investors comfort, but the trend bears noting.
Given everything we've seen about this fund, I think it could make a find choice for investors seeking exposure to the crazy world of biotech but don't want to go about picking stocks for themselves. Just be sure you fully understand what you're buying.
