Biotech ETFs – Keep Those Buyouts Coming!

The recent buyout of Idenix Pharmaceuticals (IDIX) by drugmaker Merck & Co (MRK) is another high-profile example of the race to scoop up promising biotech stocks before they hit it big.

It’s also an example of a fantastic pattern that does incredible things for biotech ETFs.

Larger companies know their aging pipelines for new products must constantly be refreshed by cutting-edge innovations that can lead to billions in future profits. That’s precisely what fueled the Idenix buyout — and the resulting 230% single-day gain that IDIX stock experienced as a result.

Of course, Idenix wasn’t the only equity moving on the deal.

This acquisition also sparked a strong rally in companies with competitive products such as Achillion Pharmaceuticals (ACHN), which is developing a similar hepatitis C treatment.

Biotech ETFs XBI
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But more importantly to ETF investors, the Idenix buyout also had an outsized impact on the SPDR Biotechnology ETF (XBI), which rose more than 6% that day. Because XBI is a modified equal-weighted index, IDIX had a much larger impact on total returns than it would for a market-cap-weighted fund such as the iShares NASDAQ Biotechnology ETF (IBB).

IDIX previously represented just 1.5% of the underlying holdings in XBI, but the recent jump has catapulted its total weight within the index to 4.5%.

The latest round of biotech M&A got me thinking about how these buyouts can positively impact ETF indices in addition to the direct equity holders.

The Virtuous Cycle of Biotech ETFs

From a fundamental perspective, the attractiveness of smaller firms that can be bought out for billions of dollars by heavy hitters is a win for many niche industry-level ETF participants.

When most indexes are constructed, underlying stocks are added or removed based on their market cap or fundamental merits according to the constraints of the index provider.

In more broad-based equity indices such as the S&P 500 Index, each participant is evaluated on a regular basis by a board of trustees. Any stock that is added or removed from the index is usually done so with modest fanfare and little net gain to the overall performance of the group.

However, with more focused groups such as XBI and other biotech ETFs, you have the potential for fireworks when an acquisition is announced.

That’s because the removal of one stock — say, in the case of a share-ballooning buyout — ultimately paves the way for another company to be added in its place as well. This continual cycle of refreshment can breed further gains within the ETF (assuming the overall uptrend remains intact).

This is why it’s critical to pay attention to index construction when selecting an ETF to add to your portfolio.

Often times, there are many competing products with similar names, but the underlying asset allocation or security selection methodology can be radically different, which can lead to significant divergences in total return over time.

In addition, the merits of both broad-based and narrowly focused ETFs should be evaluated in the context of cost, liquidity, diversification, performance and volatility.

Bottom Line

Even if they don’t want to go chasing M&A target stocks all day, investors still can benefit from significant acquisitions, speculative activity or company mergers using select funds (such as biotech ETFs) that are positioned to reap the rewards of these circumstances.

And the built-in diversification qualities of an ETF help mitigate individual business risks should the end results fail to meet shareholders expectations.

David Fabian is Managing Partner and Chief Operations Officer of FMD Capital Management. As of this writing, he did not hold a position in any of the aforementioned securities. To get more investor insights from FMD Capital, visit their blog.

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