VRTX - BBH: Our Favorite Biotech ETF Can Keep Outperforming

2023-09-13 03:08:35 ET

Summary

• VanEck Biotech ETF has outperformed alternative industry ETFs in recent years through its concentration in large-cap leaders.
• Biotech companies are benefiting from new artificial intelligence tools set to streamline and accelerate R&D programs.
• We are bullish on biotech stocks, which benefit from significant long-term growth opportunities.

The VanEck Biotech ETF ( BBH ) offers targeted exposure to the largest U.S.-listed global biotechnology stocks. The fund with around $500 million in assets is smaller than some comparable industry-specific ETFs, but we highlight some of its unique profile that has made BBH a winning choice in recent years.

Indeed, the VanEck Biotech fund has returned 26% in the past 5-years, outperforming a 10% gain from the iShares Biotechnology ETF ( IBB ) and in contrast to an -18% decline from the SPDR S&P Biotech ETF ( XBI ) as more high-profile benchmarks.

In our view, BBH's cap-weighting methodology focusing more on large caps is an advantage in this segment recognized as traditionally volatile and higher-risk. By effectively screening out smaller and more speculative biotech stocks, BBH delivers a layer of quality to the fund. We are bullish and see room for shares to climb into 2024.

What is the BBH ETF?

BBH passively tracks the "MVIS US Listed Biotech 25 Index" composed of companies involved in the development, production, marketing, and sales of drugs based on genetic analysis. Companies eligible for inclusion must derive at least 50% of their revenue from biotech-related activities . Specialized providers of diagnostic equipment are also included. There is a quarterly rebalancing.

The distinction of biotech is that this group focuses more on addressing complex diseases, like cancer, with treatments developed from living organisms like bacteria or mammalian cells. This is in contrast to traditional pharmaceuticals which are typically synthesized through chemicals.

While there have been several breakthrough treatments by biotechs over the past two decades, the understanding is that biologics often require more extensive clinical trials with closer regulatory scrutiny for final approval by the Food and Drug Administration. For example, since 2020 only 42 new biologics licenses have been approved by the FDA compared to 102 chemical compounds.

We bring this up to highlight the challenge for emerging entrants attempting to climb their way through the entire approval process. It's estimated that upwards of 90% of clinical trials ultimately fail . This aspect is what makes investing in unproven biotech companies, that sometimes only have a handful of candidate drugs in the development stage, particularly risky.

In this regard, BBH side steps that issue by focusing more on the largest established names in the industry, that have achieved success with a commercialized product and diversified pipeline.

Going through the current portfolio, we see a concentration among the industry leaders including Amgen Inc ( AMGN ), Gilead Sciences Inc ( GILD ), and Vertex Pharmaceuticals Inc ( VRTX ) among the top holdings.

While each of these names has varying business models and focuses on different drug categories, the majority of BBH investments have recurring profitability with a long-term growth outlook. By this measure, the fund's weighting methodology ends up with a tilt toward companies with relatively stronger fundamentals.

BBH Performance

We mentioned some alternative biotech funds. IBB takes a broader approach to the industry, including all types of biotech stocks, down to some micro caps. In this case, the iShares fund holds 270 different names, while having an overlap with BBH among top holdings.

The result here is that IBB has historically been more volatile than BBH, given the lagging performance among the more speculative stocks over the past decade, including development-stage biotech holdings that may ultimately fail.

With the XBI, the fund features a modified equal-weighting methodology adjusted for trading liquidity thresholds. Here the SPDR S&P Biotech ETF strategy adds importance to small caps relative to both BBH and IBB. Again, this direction has led to wider swings of volatility, considering the poor industry returns going back to the highs since the highs of 2021.

We can draw a connection from BBH's index strategy to its relative outperformance in recent years. In the last three years since 2020, BBH has returned 7%, compared to 0.4% by IBB, and a -24% loss in value from XBI. We're not suggesting BBH will always outperform over every specific timeframe going forward, but its record speaks for itself.

What the chart below highlights is that there are also certain periods when a different weighting and portfolio strategy is better suited for that particular market environment.

This includes the particularly strong period in the market at the end of 2020, XBI led the group higher with a larger climb to its peak into early 2021. The explanation there is that smaller, high-beta biotech stocks should outperform during an exceptional bull market.

At the same time, the attraction of BBH is its more balanced approach that has resulted in superior risk-adjusted returns. The argument we make is that the more concentrated large-cap positioning of BBH may be the more effective method for investors to capture biotech exposure over the long run.

What's Next For BBH?

Several industry developments have kept biotech in the spotlight. A major theme this year is the move to incorporate artificial intelligence [AI] and automation in drug discovery. Companies are using AI to model protein structures and predict their immune response in potential treatments.

For example, Amgen is seen as an early adopter in this area and has gone on record as using the latest generation of Nvidia Inc ( NVDA ) AI chips to accelerate its biologics R&D program . Separately, Moderna Inc ( MRNA ) is partnering with International Business Machines ( IBM ) in a quantum computing program to achieve similar results.

The future of biotech is likely going in the direction of more personalized medicine . With advancements in gene editing and CRISPR diagnostics, the idea here is to make medicines to each patient's specific needs. There are also significant opportunities for biotech in orphan drugs to treat rare diseases, with several companies pursuing potential therapeutic candidates.

The setup here is a positive long-term growth outlook. We can also bring up high-level trends including an aging global demographic with climbing healthcare along with high-growth in emerging markets. Overall, we expect biotech stocks and the BBH fund to perform well over the next decade.

Final Thoughts

With an expense ratio of 0.46%, BBH is a high-quality ETF that performs as intended for tactical or strategic exposure to biotech leaders. Following a period of consolidation in the industry and otherwise weak equity performance since a valuation reset in 2022, we view the current level as an attractive entry point for long-term investors.

In terms of risks, biotech remains exposed to macro themes with the possibility of a global slowdown representing a risk to watch. Renewed financial market volatility or weaker investing sentiment would open the door for further downside in biotech stocks including BBH.

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