As the name suggests, the biotechnology sector combines elements of biology with the development and manufacturing of products and business ventures. Both of these components have experienced unbelievable advances in recent decades, making the biotechnology area an exciting one for investors. Best of all, biotechnology's impact covers an ever-expanding range of tangential fields and areas, including medicine, pharmaceuticals, the environment, food, genetics and much more.

For many investors, biotech represents a real way to improve life for millions of people around the world, either through new medical treatments, better food or any number of other benefits.

Key Takeaways

  • The biotechnology sector - or biotech - includes companies that specialize in cutting edge biological science and medical devices.
  • Given its potential to create lifesaving cures and ward off disease, biotech stocks have a lot of upside potential - but also come with a greater degree of risk of failure.
  • Adding biotech to a diversified portfolio can add a growth element, but picking the right biotech stock can be a shot in the dark.
  • ETFs that track the biotech sector are a great way to get exposure to this sector without having to pick individual stocks.

Biotech Performance

Biotech companies have made up some of the top performing and most exciting stocks in recent years. Companies like Biogen Inc. (BIIB) and Celgene Corporation (CELG) seem to be perennial favorites, and there are always up-and-coming stocks entering the field as well. On the other hand, though, while a successful trial run of a new product or a research breakthrough can send stock prices to the moon, biotech companies are by no means guaranteed to thrive. In fact, the sector experiences a steady turnover of names as companies shutter their doors when things don't go as planned.

For this reason, many investors looking to capitalize on the biotech space's potential have turned to exchange-traded funds (ETFs). ETFs have dominated the investment landscape for many years, in large part because they offer investors a low-cost means of diversifying their holdings that is both quick and easy. Below, we'll examine the place that biotech ETFs can have in a variety of portfolios. First, though, we'll take a closer look at what the biotech sector is. (See also: A Biotech Sector Primer.)

What is Biotech?

For all of the promise that biotech holds, it is not without its controversies as well. The biotech sector began in earnest after the discovery of DNA in the early 1950s. In the decades immediately following this discovery, as scientists and governments learned more about DNA, it was common for countries around the world to enact laws governing what could and could not be done in this area. We still feel many of the effects of this ongoing struggle today, particularly in the world of genetically modified foods and in stem-cell research.

Biotech firms can focus their efforts in a multitude of different directions. As indicated above, biotech companies can aim to innovate in fields as diverse as food science, genetics, agriculture and health care. The last of these is perhaps the most common focal point for biotechnology companies.

Companies in the biotech space tend to face significant barriers to success. One critical reason for this is that research and development costs for biotech names tend to be incredibly high. While a company is focusing its time and money in these areas, there's usually very little by way of revenue. It's not uncommon, therefore, for biotech companies to work together with larger, more established firms in order to achieve their research and development goals. Before these goals are met, a biotech company is incredibly fragile. Perhaps this is why the biotech space, while always growing with new names, has more and more come to be dominated by a small group of large companies in recent years.

For those biotech companies in the health care space, there are additional hurdles to pass as well. In the U.S., new drugs must meet a rigorous set of requirements put in place by the Food & Drug Administration (FDA) before they can be manufactured and sold to consumers. The FDA approval process takes many years, and the large majority (as many as 95%, by some estimates) of drugs entered into the process are ultimately not accepted. (For more, see: 8 Stages of New Drug Development.)

Why Invest Using Biotech ETFs?

And yet, although biotech companies may present a number of issues that inspire caution and skepticism among investors, this sector remains one of the hottest. The potential exists for incredible gains, made on the back of sweeping and monumental discoveries and technological advancements, even if these tremendous success stories are somewhat rare. Fortunately, as technology continues to develop, the speed at which biotech companies can achieve their aims picks up as well. For all of these reasons, investors are increasingly interested in investing in the biotech area.

For many investors, the prospect of gaining exposure to a relatively wide pool of biotech names is an enticing one. The larger the basket, the thinking goes, the better protected one is against the potential failure of any single company. Biotech ETFs are a great way to achieve this diversity in a portfolio.

Just as the biotech arena is dominated by a relatively small list of major companies, so too is the biotech ETF space largely made up of a few prominent funds. The iShares Nasdaq Biotechnology ETF (IBB) was, as of March of 2018 and according to a report by the Motley Fool, the largest fund of its kind, with close to $10 billion in assets under management (AUM) and a 14% one-year return. Indeed, this ETF claims that about 80% of its assets are focused directly in the biotech space, with the remainder divided among pharmaceuticals companies and secondary outfits providing tools and services for the industry. (See also: IBB: iShares NASDAQ Biotechnology ETF.)

There are at least three other highly prominent ETFs in the biotech world. The next largest after IBB is the SPDR S&P Biotech ETF (XBI), with assets of more than $5 billion as of March 2018. With an expense ratio of 0.35% and a one-year return of 31%, this is a strong option for investors looking to explore the biotech landscape. The First Trust NYSE Arca Biotech ETF (FBT), with $1.5 billion in AUM, and the VanEck Vectors Biotech ETF (BBH), with $473 in AUM, round out the list.

Between these and other biotech ETFs, investors have some important choices to make. The largest of these ETFs tend to focus on the biggest names in the biotech sector; in doing so, these ETFs provide stability that other funds may not. However, in an effort to gain traction by capturing a unique corner of the market, smaller biotech ETFs tend to look more often to newer, up-and-coming companies. These investments provide tremendous opportunity but also higher levels of risk. There are also specialized biotech ETFs, such as the Loncar Cancer Immunotherapy ETF (CNCR), which tracks a basket of roughly 30 companies in the immunotherapy subcategory of the space.

The Bottom Line

Biotech is responsible for launching hundreds of new drug trials and developing medicines that can cure or treat a host of diseases. This is an incredibly powerful and exciting industry to be a part of, and it's no surprise that investors everywhere want in on the action. With biotech ETFs, investors have the opportunity to gain exposure to the sector without taking on the risk of focusing their investments too narrowly in a space where the stakes can be extremely high. (For additional reading, check out: Investing In Biotech: Is It Worth The Risk?)