Sector rotation is often the hallmark of a skilled investor. Booking profits in one sector and redeploying funds into another can help you stay two steps ahead of the market.
Case in point: biotechs were out of favor in 2016 but have delivered solid gains in 2017.
Yet biotech exchange-traded funds have brought home a clear lesson to investors. Namely, not all sector ETFs provide the same bang for the buck. The NYSE Arca Biotech index’s roughly 35 percent gain in 2017 has been nicely replicated by funds such as the SPDR S&P Biotech ETF (XBI) and the First Trust NYSE Arca Biotechnology Index Fund (FBT).
However, the iShares Nasdaq Biotechnology ETF (IBB) and the VanEck Vectors Biotech ETF (BBH) have only risen by around half as much. A quick glance at these funds’ portfolios and methodologies help tell the tale. “Biotech ETFs have always had a wide disbursement of returns, so the question becomes 'what’s in the portfolio and what exposure do I really want?’” suggests Elisabeth Kashner, director of ETF research at FactSet
The Large-Cap Stumble
Investors that track the biotech sector are well aware of the growth challenges facing the largest firms. Biogen (BIIB), for example, is expected to boost sales just five percent this year. Amgen’s (AMGN) revenue base will likely be flat while Gilead Sciences (GILD) is expected to post a 15 percent drop in sales. These firms are wrestling with mature product portfolios and a relative dearth of new drugs to fill up the sales pipeline.
The fact that both the iShares and Van Eck funds take a market cap-weighted approach means they will have a strong weighting in the sector’s largest players. The three above-mentioned biotech companies account for 25 percent to 30 percent of these two funds’ portfolios.
“These firms simply don’t have the growth prospects that you’ll find with smaller biotechs,” says Todd Rosenbluth, director of ETF & mutual fund research at CFRA.
So deciding to own a sector like biotech isn’t simply a matter of buying the largest and most liquid fund. Instead, you need to dig in and formulate an industry view. In this instance, says Rosenbluth, the smaller firms have been benefiting from industry consolidations.
Smaller biotech firms have frequently been acquisition fodder over the past decade. And deals often come at a sharp premium to the then-current price. Although the volume of deal-making this year will likely fall from last year’s $44 billion take, momentum in Congress to lower the tax rate on foreign-sourced profits should provide larger firms with fresh financial firepower to resume their acquisitive ways in 2018.