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Summary Since 2007, biotech and pharma funds have outperformed the S&P 500. Over the past 12 months, PJP, XPH, and FBT have booked outstanding performances. Both pharma and biotech funds are substantially more volatile than the S&P 500. As a retiree, I appreciate the drug innovations that are increasing longevity. However, I also wanted to benefit financially by investing in the companies responsible for these advances. I am not a medical doctor so it is difficult to analyze individual products. Therefore, I gravitated to Exchange Traded Funds (ETFs) and Closed End Funds (CEFs) that provide broad exposure to this sector. In February of last year, I wrote an article on Seeking Alpha about selecting the “best” pharma and biotech funds. In that article, I defined “best” as the asset that provided the most reward for a given level of risk and I measured risk by the volatility. Please note that I am not advocating that this is the way everyone should define “best”; I am just saying that this is the definition that works for me. This article updates the previous article to see how the pharma and biotech funds have performed over the past year. However, before delving into the analysis, I will recap some of the differences between pharmaceutical companies (referred to as “pharma”) and biotechnology companies (referred to as “biotech”). Both types of companies develop and sell medicine to cure or manage diseases, so the difference is a matter of focus. On a pure technical basis, biotech companies use knowledge of biology to change the functions of cells in a controlled and predictable way. These companies use manipulation of living organisms to synthesize drugs. In contrast, pharmaceutical companies typically rely on plant and chemical based compounds to create their products. From a business point of view, biotech companies are more focused on research and development (R&D) to develop novel compounds that are then taken to clinical trials. Biotech companies often operate at a loss until the new drug is approved. Pharma companies also do R&D but typically have a stable of drugs that can be sold while waiting for the next blockbuster to be developed. Conventional pharma firms tend to be profitable, which may not be the case for the smaller biotech firms. Adding these traits together means that biotech companies have a higher degree of risk than their chemical-based cousins. The stock price of biotech may be highly volatile depending on the results of a clinical trial. Thus, shareholders of biotech companies have the potential for large losses as well as large gains. Pharma companies are somewhat more predictable and are less volatile. The funds that were analyzed in my previous article are summarized below. All these funds have histories that go back to at least 2007, but in this analysis, I concentrated on near-term performance. I will touch on long-term risk and rewards at the end of the article. PowerShares Dynamic Pharmaceuticals (NYSEARCA: PJP ). This ETF focuses on 30 large cap pharmaceutical companies. It is a “quant” fund that uses a 50 factor proprietary model to rank stocks in terms of capital appreciation potential. This is a market cap weighted fund but because of its construction, the largest holding seldom exceeds 5%. It is rebalanced quarterly. It has an expense ratio of 0.6% and has a yield of 2.8%. SPDR S&P Pharmaceuticals (NYSEARCA: XPH ). This ETF tracks 30 pharmaceutical companies selected from the S&P Total Market Index. It uses an equal weight methodology with about equal amounts in large-cap, mid-cap, and small-cap companies. This ETF has an expense ratio of 0.4% and yields about 0.6%, iShares Nasdaq Biotechnology (NASDAQ: IBB ). This ETF tracks the Nasdaq Biotechnology Index that consists of 152 stocks, with over 75% in the biotech arena. About 56% of the total assets are in large-cap companies, 22% in mid-cap, and 22% in small-cap. About 95% of the companies are domiciled in the U.S. The fund has an expense ratio of 0.5% and yields a small 0.1%. SPDR S&P Biotech (NYSEARCA: XBI ). This ETF consists of 56 equally weighted U.S. companies. About half of the holdings are “early stage development” firms that are focused on pure research with no drugs on the market yet. It has an expense ratio of 0.4% and yields 1%. First Trust NYSE Arca Biotech Index (NYSEARCA: FBT ) . This is an equal-weight ETF consisting of 30 U.S. biotech companies. The portfolio consists of mostly mid-cap and small-cap firms and is rebalanced quarterly. This ETF has an expense ratio of 0.6% and does not have any significant yield. PowerShares Dynamic Biotech & Genome (NYSEARCA: PBE ). This ETF is a “quant” fund based on an “Intellidex” index. The proprietary Intellidex methodology selects 30 companies based on price and earnings momentum, management, and value assessments. About 66% of the portfolio is invested in biotechnology and most of the rest is in life science companies. Only about 25% of the portfolio is large cap with the rest divided equally between mid-cap and small-cap. The expense ratio is 0.6% and the fund yields 0.5%. H&Q Healthcare Fund (NYSE: HQH ): The price of this CEF has oscillated between a small premium and a small discount. Over the past year, the average discount has been 1% but the fund is currently selling at a 4% premium. It has 83 holdings focused on healthcare, with an emphasis on biotechnology and pharmaceuticals. It does not use leverage but many of its holdings are smaller, emerging companies. The expense ratio is 1.1% and the distribution rate is 7%, funded by long-term capital gains with no return of capital. H&Q Life Sciences Investors (NYSE: HQL ). This CEF sells at a 4% premium, which is somewhat unusual since over the last year, the fund has averaged a 1.7% discount. The fund has 88 holdings that focus on both biotech and pharmaceuticals, with more emphasis on biotech companies. The fund does not use leverage and has an expense ratio of 1.3%. The distribution rate is 7%, funded by long-term capital gains with no return of capital. To determine how these funds have fared over the past 12 months, I used the Smartfolio 3 program. The results are shown in Figure 1, where the rate of return in excess of the risk free rate (called Excess Mu on the charts) is plotted against volatility. For comparison with the overall stock market, I also included the SPDR S&P 500 ETF (NYSEARCA: SPY ) . (click to enlarge) Figure 1: Reward and risks (February 2014 to February 2015) The Figure illustrates that there has been a wide range of returns and volatilities associated with these funds. For example, FBT has generated a high rate of return but at the expense of increased volatility. Was the increased return worth the increased volatility? To answer this question, I calculated the Sharpe Ratio for each fund. The Sharpe Ratio is a metric, developed by Nobel laureate William Sharpe that measures risk-adjusted performance. It is calculated as the ratio of the excess return over the volatility. This reward to risk ratio (assuming that risk is measured by volatility) is a good way to compare peers to assess if higher returns are due to superior investment performance or from taking additional risk. On the figure, I plotted a red line that represents the Sharpe Ratio of SPY. If an asset is above the line, it has a higher Sharpe Ratio than the SPY. Conversely, if an asset is below the line, the reward to risk is worse than the SPY. Some interesting observations are apparent from the plot. First off, both the pharma and biotech funds have been extremely volatile over the past year, with volatilities substantially greater than the S&P 500. Three of the funds (PJP, XPH, and FBT) outperformed the S&P 500 on a risk-adjusted basis. Thus, the increased return associated with these funds adequately compensated the investor for the increased risk. The other funds in the analysis all beat the S&P 500 on an absolute return basis but underperformed on a risk-adjusted basis. Thus, for these funds, the increased return did not adequately compensate the investor for the increased risk. Of all the funds, XBI was by far the most risky due to its focus on early stage development firms. As expected, the pharma funds were less volatile than biotech funds. But somewhat surprising, the pharma funds also beat most of the biotech funds on both an absolute and risk-adjusted return basis. The closed end funds (HQH and HQL) ended up in the middle of the pack. If you combine all the funds into an equally weighted portfolio, the resulting composite performance (shown as a yellow dot on the figure) had almost exactly the same risk-adjusted performance as the S&P 500. Last year, I gave the nod to PJP as the best pharma fund and selected IBB as the best biotech performer. PJP was a good pick in that it continued its outperformance. On the other hand, IBB lagged. Over the past year, FBT had the best performance among the biotech funds. If you are considering investing in these asset classes, it is a good idea to assess how much diversification you might receive if you purchase more than one fund. To be “diversified,” you want to choose assets such that when some assets are down, others are up. In mathematical terms, you want to select assets that are uncorrelated (or at least not highly correlated) with each other. I calculated the pair-wise correlations associated with the covered call funds. I also included SPY to assess the correlation of the funds with the S&P 500. The data is presented in Figure 2. (click to enlarge) Figure 2. Correlation over past 12 months The figure illustrates what is called a correlation matrix. The symbols for the funds are listed in the first column on the left side of the figure along with SPY. The symbols are also listed along the first row at the top. The number in the intersection of the row and column is the correlation between the two assets. For example, if you follow XPH to the right for two columns, you will see that the intersection with HQH is 0.653. This indicates that, over the past year, XPH and HQH were 65% correlated. Note that all assets are 100% correlated with themselves, so the values along the diagonal of the matrix are all ones. The last row of the matrix allows us to assess the correlations of the funds with SPY. There are several observations from the correlation matrix. The biotech and pharma funds are only moderately correlated with SPY. Thus if you have an equity portfolio that mimics the S&P 500, then you will receive moderate diversification by purchasing any of the funds listed. Among the pharma and biotech funds, the closed end funds (either HQH or HQL) offer moderate diversification (but you would not purchase both of these CEFs since they are 90% correlated with each other). You need to be careful if you purchase more than one biotech or pharma ETF. As you might expect, PJP is highly correlated with XPH. You will gain some diversification if you purchase a pharma and a biotech that are less than 80% correlated. In summary, all the biotech and pharma funds have performed reasonably well over the past year and any of these would have been good additions to your portfolio. However, I typically have a longer investment horizon than one year, so I wanted to see how well these funds performed over the entire bear-bull cycle. So for a final assessment, I re-ran the analysis from October 12, 2007 (the high of the market before the bear market began) to the present. The results are shown in Figure 3. (click to enlarge) Figure 3: Reward and Risk over bear-bull cycle As shown by the figure, both pharma and biotech funds have had impressive performance over the bear-bull cycle, easily outperforming the S&P 500 on both an absolute and risk-adjusted basis. A portfolio of these funds (yellow dot on figure) would have generated a much higher return than SPY with about the same volatility, a truly amazing performance! Among the funds in the analysis, the pharma group had the best risk-adjusted returns. PJP had the best performance but XPH was close behind. In general, over the complete cycle, the pharma group had better risk-adjusted returns than the biotech funds. This may be because pharma stocks hold up relatively well in a bear market, since people will purchase prescription drugs regardless of the economy. The closed end funds, HQH and HQL, were more aligned with the biotech ETFs than the pharma ETFs. If we focus on the biotech group, IBB had the best risk-adjusted return, with both HQH and FBT close behind. PBE was the laggard of the group. Bottom Line Both pharma and biotech funds have demonstrated good to excellent risk-adjusted performance over the preceding several years, with PJP, XPH, and FBT leading the pack. No one knows what the future will bring but with 78 million baby boomers reaching retirement age, I believe biotech and pharma funds will continue to be good bets. If you are a risk tolerant investor, then I think these funds deserve serious consideration. Disclosure: The author is long HQH, PJP, FBT. (More…) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article. 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