As the universe of exchange-traded funds (ETF) expands, investors are being thrust into a land of confusion. There are more than 100 different international ETFs to choose from right now. There are even three separate and unique ETFs that specialize in water. Where do investors turn?
The majority of ETF investors do not realize there are five biotech choices available for purchase. What is more amazing is that the public sees "biotech ETF" and assumes all five must be interchangeable; However, in the first 7 months of the year the biotech sector has been flat, but the five ETFs that track the sector have been all over the board. Read on as we delve a little deeper into biotech ETFs and the disparity in their returns.
Biotech Buyers Beware
I hate to be the bearer of bad news, but there is a drastic difference in ETFs that claim to track the same sector. The variations are very noticeable in the returns of the biotech ETFs in the first seven and a half months of the year. Of the five biotech ETFs the best performer year-to-date through August 16 was the SPDR S&P Biotech ETF (NYSE:XBI) with a gain of about 14%. On the opposite end of the spectrum, HOLDRS Biotech ETF (NYSE:BBH) had a loss of 12% in the same timeframe.
In monetary terms, a $100,000 investment in XBI at the beginning of the year would now be worth about $114,000 and the BBH investment a mere $88,000. The BBH must put together a 30% increase just to get to even with the XBI. Keep in mind this took place in less than eight months time.
Looking Inside the Sector
To put the numbers into perspective, the AMEX Biotech Index lost 0.3% and the S&P 500 was down 0.5% in the same period. Therefore the XBI greatly outperformed the benchmarks, and BBH was a clear laggard. The other three biotech ETFs had a much more muted start to the year: iShares NASDAQ Biotech ETF (NYSE:IBB) -1.8%, First Trust AMEX Biotech ETF (NYSE:FBT) -0.8%, and PowerShares Dynamic Biotech ETF (AMEX:PBE) 3.1%.
Stocks vs. ETFs
By delving further into the numbers and looking at all biotech stocks we follow (204 total), the case for a biotech ETF strengthens. Of the 204 biotech stocks, only 23% were able to outperform XBI. As a matter of fact, only 52% had better returns than the 12% loss of BBH.
So, why would anyone invest in a biotech stock if the odds are the ETF will be able to outperform over half the time? It is a combination of greed and perceived stock picking abilities. The greed factor comes in because investors are over confident and want to go for the big winners. There was a 2% chance investors could have picked a stock that doubled. Even though the odds are small, there is still the chance. (To learn more, see Master Your Trading Mindtraps.)
At the same time, two out of every three biotech stocks were in negative territory. Well, maybe investors do not need to get the stock that doubles, but they feel they can outperform even the best biotech ETF. There was an 18% chance the investor could have picked a stock that gained over 20%. However, the possibility of picking a stock that lost at least 20% came in at 41%. Again the numbers are not favoring stock picking.
How about the possibility of picking a biotech stock that gets hit with negative news and takes a massive hit? Unbelievably, 13% of all biotech stocks lost at least 50% in the first seven and a half months of 2007.
Inside the ETFs
The reason for the major differences in returns of the ETFs has to do with their composition. The top performer, XBI, is very diverse and its largest holding makes up less than 4% of the entire allocation. The underperformance on BBH can be directly linked to its top three holdings, which make up 75% of the entire portfolio. Genentech (NYSE:DNA) and Amgen (Nasdaq:AMGN) are the top two holdings and are considered mega-cap biotech names that have returns of -9.8% and -27.7%, respectively.
I would not consider BBH an investment option unless I had intentions of purchasing all three of its top holdings separately and therefore could do so with the single purchase of an ETF. However, nearly all investors turn to ETFs as an investment vehicle to eliminate stock-specific risk and that is clearly not the case with BBH.
Of the five biotech ETFs, two that stand out above the others are XBI and PBE, because both have exposure to the large-cap names as well as some of the "junior" biotech stocks. By giving the ETF exposure to the small-cap and mid-cap names, it allows for the probability of owning a big winner, but at the same time one or two big losers will not ruin the returns of the ETF.
ETFs Win This Round
Right now, ETFs are clearly the better choice in the biotech sector for risk averse investors who would like to gain a true exposure to the entire arena. However, keep in mind you must look at the components of all ETFs before you consider making a purchase.
For related reading, see An Inside Look At ETF Construction.
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