One of the best market tips I’ve ever received was about how to invest in biotech stocks. Specifically, unless you’re the rare person who knows the sector cold, single-stock picks are just gambles — individual investors are instead better off playing biotechs via exchange-traded funds.
But that doesn’t mean all biotech ETFs are worth your time.
Following a go-go 2013 that sent the iShares Nasdaq Biotechnology ETF (IBB) up as much as 55% as of last week, the IBB took an insecurity-sparked gut shot of about 10% as America really started to accept that Washington might not settle the debt ceiling impasse by the Oct. 17 deadline. Another major biotech fund — the SPDR S&P Biotech ETF (XBI) — fell as much as 12%.
Then, investors were suddenly thrust into another “There’s a fund for that!” moment.
Busy Week for BIS
A couple articles came out that day touting the change of fortune for the ProShares UltraShort Nasdaq Biotech ETF (BIS), which seeks to double the daily inverse performance of the IBB’s benchmark, the Nasdaq Biotechnology Index.
In theory, for every 1% the IBB loses, the BIS should improve 2%. In practice, it’s a much different thing. ProShares itself points out as much, writing, “Due to the compounding of daily returns, ProShares’ returns over periods other than one day will likely differ in amount and possibly direction from the target return for the same period.”
Still, while it wasn’t a perfect two-for-one, BIS had an expectedly good run.
So, considering a debt ceiling deal remains in limbo and uncertainty remains rampant, we should all start jumping into BIS, right?
No. Good grief, no.
A handful of traders with big speculation allocations and bigger cajones might give BIS a further whirl, but the vast majority of investors shouldn’t touch this inverse fund. That’s not only because BIS shares a common risk with leveraged funds in that it can amplify your pain … but also because the windows of opportunity for biotech bears are small and lined with glass shards. This longer-term chart should give you an idea:
What you’re looking at here isn’t actually all that atypical. Generally speaking, U.S. stocks as a whole (as well as many sectors and subsectors) improve over long periods of time, so leveraged inverse funds betting against that trend are destined to decline. Thus, you’ll see charts like this for many inverse funds — including reverse splits executed just to keep these funds in existence.
However, BIS in particular has had very little time in the sun. ETF Trends’ Tom Lydon points out a highlight of the fund’s existence:
“When biotech is out of favor, however briefly, BIS can really move. The sector struggled a bit around this time last year. BIS proceed to surge 27% from mid-October through November 8, 2012.”
That’s a big move, but a period of opportunity of only three weeks — about as long as you’ll find across BIS’ three-plus years of trading. Market timing is a fool’s errand anyway, but that’s doubly so when working with mere slivers of time.
Short Biotech at Your Own Peril
BIS has been pounded so badly because in a stock market where nothing is certain, biotech is as can’t-miss an industry as you’ll ever find.
The biggest driver is an aging population here and globally, fueling a push toward a host of life-extending treatments. At the same time, improved knowledge about genetics is causing an explosion in new drugs for various diseases.
That makes biotech stocks awfully macro-proof. Sure, biotechs can suffer broadly when economic issues hammer investors’ risk tolerance, but for the most part, individual biotech stocks live and die on their own businesses. The real risk is poor trial-stage news or FDA rejections … but then, diversified funds like IBB and XBI shield you from that kind of individual-company risk.
Meanwhile, biotech stocks have a one-two punch of profit potential. For one, the flip side of trial/FDA risk is that a single treatment approval can send biotech stocks up by double and even triple digits in a day. Also, Big Pharma’s constant race against the patent expiration clock puts many of the most promising companies on M&A watch.
That latter point itself is a double blessing, as deals not only tend to result in price spikes, but any bought-out company held by a biotech ETF usually is replaced by another company, which itself has the potential to continue the virtuous cycle.
All this is a recipe for euphoria in IBB and pain in IBB:
Leveraged inverse funds are one of the quickest ways to lose your pants in the first place, especially if you’re not an experienced daytrader — but you’re really stacking the deck against yourself by betting against a perpetually strong industry such as biotech.
In fact, if you’re looking for market-beating gains that can pile up in a hurry, one of your safest bets might be going long biotech when the going’s tough.
Kyle Woodley is the Deputy Managing Editor of InvestorPlace.com. As of this writing, he was long IBB. Follow him on Twitter at @IPKyleWoodley.