PowerShares Dynamic Pharmaceuticals (NYSEARCA: PJP) is an exchange-traded fund (ETF) that tracks the investment results of the Dynamic Pharmaceuticals Intellidex Index, which is composed of pharmaceutical companies that are selected using a multifactor proprietary model. Since its inception in 2005, the fund has demonstrated an annual average rate of return of 19.2%, which is significantly higher than the return of the overall market.

The pharmaceutical industry enjoys significant barriers to entry, and current patent laws offer unique protection against future entrants and distinct competitive advantage. Typically, drugs are nondiscretionary products since an ill patient needs treatment independent of general economic conditions. Also, the aging population in the United States and elsewhere in the world presents a unique opportunity for pharmaceutical companies to enjoy sustained growth in the future. The PowerShares Dynamic Pharmaceuticals ETF was created for this exact reason, to take advantage of the growth potential of the drug industry.

PJP uses a passive indexing approach to follow the Dynamic Pharmaceuticals Intellidex Index, whose 26 pharmaceutical stocks are selected using the proprietary ranking of drug companies based on their capital appreciation potential. About 60% of the fund's holdings is invested in large and giant market cap pharmaceutical companies, while about 30% is allocated to small drug companies. This ETF differs from similar funds by the fact no single company accounts for more 5 to 6% of the total holdings.

Each of the top five companies account for about 5% of the fund's portfolio; these include Amgen, Depomed, Allergan, Gilead Sciences and Pfizer. About 95% of the fund is invested in companies that develop their drugs in North America, and the fund has a 2.46% yield as of August 2015. At the end of each quarter, PJP rebalances its portfolio after evaluating each company for different criteria, such as earnings quality, price momentum and value.

Characteristics

The PowerShares Dynamic Pharmaceuticals ETF is an open-ended investment company that was created in 2005 by Invesco. Since the fund follows a passive investment strategy, PJP's expense ratio stands at 0.58%, which is lower when compared to the typical mutual fund that focuses on the drug sector but is somewhat higher than the expense ratio of 0.45% for a similar health-care ETF. The fund is traded on the New York Stock Exchange (NYSE) and can be purchased through multiple broker platforms.

Suitability and Recommendations

Investing in PJP comes with risks associated with the drug industry. First, there is a lot of uncertainty with respect to research and development for drugs. There are many instances when pharmaceutical companies fail to achieve their drug development milestones or obtain approval from regulatory agencies to market and sell their drugs. Also, the drug sector is prone to patent cliff, where the patents for highly profitable drugs expire. If there is no replacement for these drugs, the generic drug companies are allowed to fiercely compete with drugs that lost their exclusivity. Investors who wish to invest in PJP should pay particular attention to drug pipelines and any patent expiration of PJP's holdings.

For investors who follow the modern portfolio theory (MPT), PJP is most suitable for growth investment. The demand for pharmaceutical products is poised to increase in the future, leading to excess returns for drug companies.

Based on the risk/reward assessment, the ETF generates significant upside with low amount of volatility. In particular, the fund's three-year Sharpe ratio of 2.43 significantly exceeded the Sharpe ratio of 1.43 for the S&P 500 index. This is due to higher-than-average returns and low volatility. The five-year standard deviation is 12.95%, which is only slightly higher than 12% for the S&P 500 index. At the same time, the five-year average return for PJP was 35.5%, which is significantly higher than 16% for the S&P 500 index. This ETF is most appropriate for investors who want to gain exposure to the pharmaceutical sector. Because of the fund's narrow focus, investors should diversify PJP holdings with stocks from other sectors of the economy.