LifeSci Index Partners LLC today did a double-fisted product launch with two passively managed biotechnology exchange-traded funds centered on opposite ends of the product spectrum––one focuses on companies with lead drugs in human clinical trial stages; the other on companies with approved products.

As its name implies, the BioShares Biotechnology Clinical Trials Fund (BBC) invests in companies focused on testing their experimental drug candidates in human clinical trials. These generally are smaller and younger companies with no revenue or profits, and which stay in business by managing their cash burn rate and equity financing strategy as their products wend their way through the Food and Drug Administration testing process in hopes of creating a blockbuster drug.

The BioShares Biotechnology Products Fund (BBP) invests in companies with at least one FDA-approved drug on the market. As noted in the company literature, these are more established companies with “much clinical trial failure risk behind them.”

The BBC fund tracks the LifeSci Biotechnology Clinical Trials Index, while the BBP fund mirrors the LifeSci Biotechnology Products Index. Both indexes were developed by LifeSci Index Partners, a New York City-based investment advisor and index provider. The company says the indexes were created by scientists with PhDs in organic chemistry, molecular biology and neurobiology, as well as seasoned investment professionals with experience in the health-care field.

Both funds sport an expense ratio of 0.85 percent, which depending on your cost sensitivity is significantly more than the range of 35 to 60 basis points charged by existing biotech ETFs.

But LifeSci executives say the extra cost is part of the process of creating biotech indexes that are unlike the indexes that underpin other biotech funds.

“We’ve created indexes that are pure biotech companies, says Paul Yook, LifeSci Index Partners’ co-founder and portfolio manager. “By our analysis, the other biotech indexes that ETFs are based on are between 65 percent and 88 percent biotech.”

He adds that other biotech-related indexes include generic drug companies, life science companies that make research and laboratory equipment, and other biotech-related companies that aren’t actually biotech stocks.

“Our argument is if you want to buy a biotech fund, you should buy pure biotech,” Yook says. He notes the bifurcation between companies strictly in the clinical trials stage and those with products on the market hasn’t been done before, and the two different funds resulting from that provides investors with different options in the sector regarding risk/reward profile.

“Biotech is one of the most dynamic sectors in the market today,” Yook says. “We’re very optimistic about the outlook for 2015 and beyond. The difference in expense ratios measured in basis points [between the BioShares ETFs and existing biotech funds] isn’t that meaningful in the context of the expected growth in biotech.”

The BioShares Biotechnology Clinical Trials Fund seems particularly intriguing, if not a bit scary given that a small biotech company whose product receives a thumbs down from the FDA typically sees its stock get pummeled.

“Companies in the BBC fund are developing the lifesaving medicines of tomorrow, and some of these companies will have clinical data and FDA approvals which will result in massive stocks movements,” says LifeSci Index Partners CEO Andrew McDonald. “On the other hand, if their products fail in development, they move massively to the down side. From that perspective, it’s a more volatile, high risk/high reward fund.

“But the fact is some of these companies will succeed and bring their drugs to market, and they’ll eventually migrate to the BBP,” he adds.

Holdings in the respective indexes that underlie the BBC and BBP funds must have minimum market capitalizations of $250 million, have demonstrated institutional backing and have a minimum average daily volume of $1 million. In addition, both indexes are equal-weighted.

The BBC fund has 68 stocks and the BBP fund has 36 stocks. Regarding the therapeutic focus of the funds, McDonald says oncology is the largest sector––about 38 percent of the companies in BBC are focused on cancer drugs and roughly 28 percent of the companies in BBP have an oncology product on the market.

Other sizable focus areas for the funds include infectious diseases, genetic diseases and neurology.

McDonald notes the average weighted market cap of the BBC fund is about $1.2 billion, while the average weighted market cap of the BBP fund is almost $18 billion. Holdings in the latter fund range from Gilead Sciences, a nearly $154 billion market cap company noted for its blockbuster hepatitis C drugs, to relatively small companies with market caps close to the portfolio’s $250 million minimum.

Hot Sector
The biotech sector––as measured by the NYSE Arca Biotech index––has been on fire with average annualized returns of more than 47 percent during the past three years. It was up nearly 41 percent year-to-date as of yesterday, despite last week’s mild sell-off.

It’s enough to make investors wonder whether the BioShares funds are launching just as biotech stocks are ripe for a pullback. Earlier this year the NYSE Arca Biotech index plummeted nearly 20 percent during a seven-week stretch from late February through mid April before bouncing back with gusto. And in July, Federal Reserve chief Janet Yellen said valuations among small-cap biotech and social media stocks appeared to be “substantially stretched.”

But the team at LifeSci Index Partners believes those concerns are misplaced, at least for the sector as a whole.

“When you look at the large-cap biotech companies that are driven by earnings, their earnings multiples are in the middle of the historic range even though biotech has been red hot,” McDonald says. “What’s driving this is that these companies are bringing products to market and are selling them, and they’re revenue and earnings stories. I hate to use the word 'mature,' but certainly the biotech industry has matured. So despite Janet Yellen’s comments about the industry being at the top, I don’t think that’s supported by the numbers.”