Biotech ETFs have had a banner year, earning some investors returns north of 30 percent since January. I say “some investors” because, it turns out, not all biotech ETFs are created equal.
In our 2012 first-half performance charts , biotech ETFs make up three of the top-four-performing funds. That’s out of all ETFs on the U.S. market, an impressive performance.
But looking more closely at their general success, some of those biotech ETFs returned far more to their investors than others.
If you invested in the top-performing fund on Jan. 1, you would have earned a 37 percent return on your money. If you invested in the worst-performing fund, you’d have earned just 14 percent.
A lot of times, particularly in the hyperventilating tone so common in financial journalism, the focus of ETF articles is on the hottest trend:a niche market of bonds, the latest industry to invest in, etc. The actual ETFs, and their inner workings, are almost an afterthought.
That is at odds with the fact that the largest determining factor in the returns of an ETF is the index it tracks. Hence the 23 percentage points in return you’d have missed by choosing the wrong biotech ETF this year.
In this case, we can do a midyear review of the ETFs in question, and look at how they differed and get a sense of what drove their returns.
To set the stage, five ETFs offer biotech exposure; one offers global exposure while the other four invest in U.S. firms alone.
Of the U.S.-focused ETFs, the index strategies differ.
The iShares Nasdaq Biotechnology ETF (NYSE Arca:IBB) is the only fund to use a straight-ahead market-capitalization approach to weighting its holdings. It’s also the most broadly diversified, spreading its assets among more than 100 biotech firms. Its quirks lie in its selection methodology:the ETF will only hold stocks listed on the Nasdaq exchange.
That doesn’t turn out to hugely affect its holding though—most biotech firms list on Nasdaq anyway. In other words, the fund is, for the most part, a well-diversified take on the whole U.S. biotech market.
The First Trust NYSE Arca Biotechnology ETF (FBT) eschews market-cap weighting in favor of equally weighting its constituents, and it has done significantly better than IBB this year.
The equal weighting assigns more assets to the smallest players in the market than does a fund like IBB, so it reaps outsize benefits from the growth of the little guys, which can be explosive.
For example, FBT gives identical exposure to the biotech powerhouse Amgen as it does to the lesser-known Sequenom Inc., and all told, it devotes nearly a third of its portfolio to small-cap stocks.
BBH, the Market Vectors Biotech ETF (BBH), is ostensibly a global ETF, but in practice, holds almost entirely U.S.-based firms. The fund is also the only market-cap-weighted and market-cap-selected biotech ETF. What that means is that the fund holds firms according to their value in the market—firms with higher valuations make up a larger part of the portfolio.
It also means the fund plays the role of a sort of market benchmark, mirroring the holdings of the market at large, though it is limited to just 25 holdings. BBH has earned the third-best returns of the biotech ETFs this year.
The PowerShares Dynamic Biotech and Genome Portfolio ETF (PBE) has been the laggard of the bunch. It has a very different take on the market than the other ETFs, using a quantitative strategy to select and weight its holdings.
Its consideration of factors like price momentum in selecting biotech firms has only hurt investors so far this year. That said, the fund places heavy bets on the smaller end of the scale—the ETF is more than 40 percent in small-caps.
Lastly, the best-performing fund in the segment was the SPDR S'P Biotech ETF (NYSE Arca:XBI), another equal-weighted fund. Just as FBT does, XBI allocates heavily to small-caps; in this case, even more so. The fund has 40 percent of its holdings in smaller names, giving it a pretty big tilt away from the market as a whole.
There aren’t any easy conclusions to draw here about optimal portfolio construction, but it’s clear that the index an ETF tracks can really affect returns.
The top-performing biotech funds this year were equal weighted, suggesting small-cap stocks may have determined their success. The performance of PBE, which allocates heavily to small-caps, stands in the way of that theory—again, it had the worst returns of the bunch.
It’s also worth noting that equal-weighted funds haven’t always done so well. If you extend the holding period to 12 months, market-cap funds have significantly outperformed the equal-weighted funds that have done so well this year.
It the same message every time:Know what you’re getting into and why.
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