The Best Way to Buy Biotech Stocks: A Heated Debate

Let’s be honest. “Investing” in biotech stocks is akin to buying a PowerBall ticket: alluring possibilities, but the odds aren’t always in your favor.

biotech stocks
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Alright, perhaps we’re stretching things a bit there. Investors have better odds, though still not great, of finding winning biotech stocks than they do of winning PowerBall.

With that in mind, the best way of investing in biotech is via a single stock — with these caveats:

  • It’d be nice to buy a stock like Amgen (AMGN) or Gilead Sciences (GILD) in its infancy and hold it for 10 years.
  • Or if you can’t do that, the second option is to buy a small-cap biotech right before it releases positive FDA trial data and enjoy the epic gains that come with such a scenario.
  • The other option is to buy a small-cap biotech with the hopes of it being acquired by an Amgen or Gilead. Hey, it happens all the time.

These are not far-flung concepts, but the probabilities of investors consistently picking the next story stock in the biotech realm are not high.

So from a more realistic standpoint, exchange-traded funds are the superior avenue for investing in biotech stocks.

Don’t scoff at ETFs as an excellent way of accessing biotech stocks. After all, over the last several years, each year’s list of the top 10 ETFs contains multiple biotech funds and the returns offered by biotech ETFs since the March 2009 market bottom are simply stunning.

Here are a few examples:

Biotech Stocks: First Trust NYSE Arca Biotechnology Index Fund (FBT)

The First Trust NYSE Arca Biotechnology Index Fund (FBT) is the best-performing non-leveraged ETF since the March 2009 market bottom. In the past three years, FBT has soared 182%. The $3.78 billion FBT charges 0.58% per year, or $58 per $10,000 invested.

FBT tracks the NYSE Arca Biotechnology Index Fund, and given the ETF’s stellar long-term returns, one might argue that it really doesn’t matter what index the fund follows. But that’s not the proper way to look at ETFs. These are passive investments, so it really matters what each ETF’s underlying index is.

In the case of FBT, the fund holds just 30 stocks — a small amount compared to some of its well-known rivals. The median market value of FBT’s holdings is $8.9 billion, but the fund’s components range in weight from just under 2.2% to just under 4.2%, meaning large-caps drive this ETF as much as small-caps do.

Biotech Stocks: iShares Nasdaq Biotechnology ETF (IBB)

The iShares Nasdaq Biotechnology ETF (IBB) is the largest biotech ETF with $8.4 billion in assets under management. IBB charges 0.48% per year.

As is the case with its rivals, it’s impossible to quibble with IBB’s long-term returns, as the ETF has surged an amazing 360% over the past five years.

IBB tracks the Nasdaq Biotechnology Index, and again, knowing the fund’s index is important. In this case, IBB holds nearly five times as many stocks as FBT. That sounds like a diverse fund, but IBB is top-heavy. As an ETF that weighs its holdings by market cap, IBB is predictably dominated by the largest biotech stocks.

In this case, Celgene (CELG), Amgen, Gilead, Regeneron Pharmaceuticals (REGN) and Biogen (BIIB) combine for nearly 40% of IBB’s weight. That is not a bad thing, but it means investors in this fund depend on the biggest biotech stocks to consistently be the sector’s leaders.

Biotech Stocks: SPDR S&P Biotech ETF (XBI)

When it comes to the best way to invest in biotech, at least via the well-established ETFs available to investors, the choice is the SPDR S&P Biotech ETF (XBI).

Notably, this choice is not based on past performance as XBI is up “just” 336% over the past five years, lagging IBB over that period.

XBI, which charges 0.35%, is sort of a best-of-both-worlds approach. That means it applies an even more refined equal-weight methodology than is seen in FBT while holding 105 stocks, putting it closer to IBB than FBT in terms of number of holdings.

The weighted average market value of XBI’s holdings is nearly $9 billion, by no means small, but unlike its two rivals mentioned here, XBI does not feature any of the five largest biotech companies among its top 10 holdings. In fact, neither Gilead nor Biogen command weights of at least 1% in XBI.

What makes XBI alluring is its ability to be responsive to upside moves in mid- and large-cap biotechs, but more important than that are two coveted traits that we mentioned earlier. Due to its significant exposure to smaller biotech stocks, XBI can be immediately responsive to big one-day moves by companies delivering favorable trial data or moves caused by takeover news.

No, it is not unheard of for smaller biotech stocks to double or triple in a single day due to one of those catalysts, but investors might assume, given the structure of an ETF like XBI, that it might be hard for that fund to move much on the back of those headlines.

However, over the course of XBI’s history, there have been numerous instances when one of its holdings with a weight of just around 1% or less doubled or tripled in a single day, helping XBI to a gain of 7% or 8%.

As of this writing, Todd Shriber did not hold a position in any of the aforementioned securities.

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