Summary Biotechnology companies have experienced a sharp selloff, leaving many of them at favorable valuation. Some might consider this a timely opportunity for investing in biotech. One can invest in the biotech sector via passively managed ETFs or actively managed closed-end funds. Here, I compare the CEF alternatives for biotech to IBB. Biotech has been battered recently. Early in the year, there was all that talk of bubbles, which became something of a self-fulfilling prophecy, culminating in a lot of air slowly leaking from the inflated category. Then, the entire market entered its long-predicted, long-awaited correction and biotech dropped along with it. Finally, last Friday, the NY Times and Hillary Clinton piled on, taking issue with excesses by some in the industry, and the category tumbled as the week began. Depending on your view of things, biotech is dead in the water for the foreseeable future and to be avoided, or it’s become horridly oversold and ripe with bargains. If you’re in the first category, you might as well stop here because everything that follows is predicated on the point of view that biotech has generally fallen well below fair price levels. Morningstar’s analytics tend to agree. Here’s its view of the industry as of Sept. 21, which considers the industry to be 14% under fair value: (click to enlarge) It can, of course, go lower, but it hasn’t been this low since 2011. Ok, you’re still reading. Either you agree that biotech is an investable industry or you’re just hanging around to hear more. But, I’m not going to discuss the merits of the industry. That’s been done repeatedly and eloquently by others. DoctoRx is a particularly knowledgeable interpreter of the biotech space; his articles and instablogs are required reading on the topic. What I want to do is explore opportunities for investing in the industry. There are certainly very attractive individual holdings, but my inclination, especially in a volatile and unpredictable area such as this, is to invest broadly using ETFs and CEFs (closed-end funds). That will be the today’s topic. I’ll focus on one ETF and two CEFs. The ETF: iShares NASDAQ Biotechnology ETF (NASDAQ: IBB ) IBB is the standard bearer for biotechnology investors. The fund’s inception date is Feb. 5, 2001. It holds net assets of just over $9B in 145 names. Holdings break down at about 79% Biotechnology, 15% Pharmaceuticals, and 6% in Life- and Bio-Sciences Tools, Services and Supplies. The expense ratio is 0.48%. IBB is indexed to the NASDAQ Biotechnology Index. Components of the index must be listed on the NASDAQ, have a market cap of at least $200M, and trade an average daily volume of at least 100,000 shares. The ETF’s top holdings are: The Closed-End Funds: Tekla Capital Management Two closed-end funds have a longer history in biotechnology. Both are from Tekla Capital Management. Tekla Healthcare Investors (NYSE: HQH ) has an inception date of April 23, 1987. Tekla Life Sciences Investors (NYSE: HQL ) began on May 8, 1992. So, both funds have a long history behind them. The Tekla funds are very similar but have important distinctions. From the Tekla website : “HQH … is broadly based in healthcare. HQL is more focused on life science technology, … expanding the biotechnology focus a bit to include more agricultural biotechnology and environmental technology. Both Funds hold small emerging growth companies, however, given HQL’s technology focus the holdings tend to be somewhat smaller and a little more volatile. The Funds share the same portfolio manager, Daniel R. Omstead, PhD.” HQH has $1.21B in assets under management; HQL has $0.52B. Management fees are 1.13% for HQH and 1.32% for HQL. Top holding for the CEFs are: (click to enlarge) For most closed-end funds, income is a major consideration; HQH and HQL are no exceptions. The funds have a managed distribution policy that distributes 2% of the funds’ net asset values to shareholders quarterly. One can opt to receive the distributions in cash. However, befitting an investment arena that is primarily growth oriented, the default option is for shareholders to reinvest the distributions by receiving them as stock. Not surprisingly, as few of the funds’ holdings pay dividends, distributions are primarily from capital gains. If, however, gains are insufficient to meet the distribution, shareholders are paid return of capital. For both funds, the managers had to resort to return of capital for only two of their quarterly distributions, these for the first two quarters of 2009. Thus, for 28 years [HQH] and 23 years [HQL] have been able to return 8% annually to shareholders from capital gains and income with only 2 misses during the depths of the worst recession since the depression. Currently, HQH is priced at a slight discount (-1.13%) to its NAV and HQL is priced at a slight premium (0.71%). For both, premium/discount levels move up and down regularly. They tend to track each other closely for this metric. (click to enlarge) Performance Total performance for the ETF and the two CEFs over intervals covering up to the past five years is shown below (based on monthly data through Sept. 1, 2015, from Yahoo Finance). (click to enlarge) There is little to differentiate the funds on a performance basis. HQH has not outperformed both of the other two for any of these time spans. HQL has done so, primarily on the basis of its strong performance TTM. HQL’s returns are, as expected, somewhat more volatile. We can see this in this chart of rolling 12-month returns since 2007 (through Sept. 1, 2015). (click to enlarge) The CEFs seem to have deeper troughs, notably through the recession and during early 2014. Premiums and discounts affect the CEFs but not the ETF. The 2014 shortfall is to some large extent a consequence of the funds falling into deep discount valuations. IBB fell well below the CEFs in 2011. I’ve not done a maximum drawdown analysis, but it seems probable that IBB wins on that front but not by a large margin depending on the time frame being considered. HQH has better risk-adjusted returns as shown in this table (data for 3 years from Morningstar). IBB fares least well with its standard deviation indicating a much more volatile fund. HQH, HQL or IBB? It is interesting that there is little to distinguish these three funds on a performance basis over a substantial time scale. From reading the objectives, one might expect more divergence in the performance figures. However, looking at the top holdings, it is clear that, at least for the top ends of the funds’ portfolios, they are fishing in nearly identical ponds. One might be inclined toward the CEFs on those occasions when an investment can be timed to catch a deep discount. An entry at a -6% to -8% discount can cushion downside movements as they occur. And, as we see in the premium/discount charts above, those discounts have consistently returned to premiums over time. On the other hand, I would tend to avoid an entry into either HQH or HQL at any appreciable premium valuation in favor of purchasing IBB. One strategy might be to buy HQH or HQL when the discount is highly favorable, hold the CEF until it moves to a premium, then sell and invest the proceeds in IBB, repeating the cycle as appropriate. Income is a factor. For the investor interested in generating income, the CEFs are the clear choice. One could, of course, hold IBB and sell 2% of shares each quarter and likely end up in about the same place. But, to my mind, it is easier to simply have the fund managers do it for you. A strong advantage of HQH and HQL over nearly all other income-generating CEFs is their long record of increasing principal even after providing a payment of 8% on NAV annually. For both funds, market price has more than doubled over 5 years, and that’s after paying out 2% on NAV each quarter. This puts them at the very top of all closed-end funds. To illustrate how the funds would have rewarded an income investor, I present this chart showing total return (distributions reinvested) and price return (distributions taken as cash) for IBB, HQH, HQL and two equity-income CEFs from Eaton Vance. One is an unleveraged option-income fund (NYSE: ETV ); the other is a leveraged global equity fund (NYSE: ETG ). These may not be the best performers, but neither has been a laggard and, taken together, I think they are reasonably, albeit arbitrary, representatives of equity CEFs. (click to enlarge) The red-orange line shows growth of the fund with income withdrawn. HQH grew 160% while providing 8% cash to its investors annually. HQL grew 170% with the same cash yield. ETV and ETG generated higher distribution yields, but did so with essentially no growth of capital over the five years. For the investor focused primarily on growth, either of the CEFs has provided returns to IBB when held with the default option of taking the distributions as shares (blue lines). In closing, I’ll mention that there are other ETFs available to the biotech investor. I’ll be following up with a survey of those alternatives.