Biotech ETFs have thoroughly enjoyed the prolonged bull run in markets. The sector was having a banner year in 2015 before August pared returns across the board but, fueled by increased political attention to pricing, biotech was among the hardest hit.

We recently caught up with Paul Yook of Bioshares to discuss the pullback, why they avoid stocks like Valeant, and what threats he sees in biotech’s future.

  1. There was recently a sector-wide pullback following pointed “price gouging” criticism leveled at the pharmaceutical industry. Do you think this warranted a sector-wide pullback, or was this symptomatic of larger trends? What are some other important signals to pay attention to as a biotech investor?

Paul: Discussions regarding the high prices of prescription drugs have always made headlines, however political discourse always increases into the election cycle. This year has been more heated than in the past because of several notable specialty pharmaceuticals companies in the news like Turing Pharmaceuticals and Valeant Pharmaceuticals. For investors investing in pharmaceuticals and biotechnology, volatility should be expected and given the strong 5 years of returns investors have enjoyed, the time was ripe for a drop. However, the magnitude of the drop was surprising to many, myself included. I do think some stocks and sectors were fairly punished, but there was significant pressure selling, particularly in smaller and mid-sized biotechnology companies and among the more innovative specialty pharmaceutical stocks, which has created interesting opportunities on the long side.

  1. “Pure play” biotech funds BBP and BBC outperformed broad-based IBB by more than 10% through July’s peak. What would you say accounts for this outperformance? How does the structure of your funds enable this divergence?

Paul: I think two of our index design factors have helped our investors. First, by equal-weighting rather than market-weighting, our funds have greater exposure to smaller companies. We look at the “weighted market cap” of fund holdings, and for IBB that is nearly $50 billion, compared to $18 billion for BBP and $1 billion for BBC. This means that the typical holding in BioShares funds tends to be smaller, and thus the management team tends to own a larger percent of the companies and can more directly impact the direction of the firms. Smaller cap biotech companies have generally outperformed the larger companies. The second factor that has positively impacted results this year is continued M&A activities. 5 companies in BBP and 4 companies in BBC have been acquired this year, and this kind of activity tends to be most helpful to small and mid cap biotech companies, rather than the larger companies.

  1. Your BBC and BBP ETFs are built specifically to exclude specialty pharmaceutical stocks such as Valeant (VRX). Why?

Paul: We launched our BioShares funds to invest purely in the biotechnology sector, which is among the most innovative and research-intensive sectors of the economy. The engine of this growth is the talented human capital – the scientists and medical professionals who run the companies and work in their laboratories, designing novel molecules and testing potential cures. The largest biotechnology companies such as Amgen and Biogen spend 20% of their sales on R&D expenses, and smaller companies spend even more. In contrast, specialty pharmaceutical companies such as Valeant, Horizon, Mallinkrodt and Akorn spend between 3% and 6% of sales on R&D.

Specialty pharmaceutical companies are a diverse group of companies with varied business models. Some work on drug formulations and delivery technologies while others focus on M&A to acquire underappreciated or underpriced drugs. Others focus on making relatively minor modifications to already approved and proven drugs. In general, these companies have lower developmental risk to get products to the market, but also in general reap lower financial rewards as their drug portfolios tend to be the breakthrough curative treatments that the biotechnology sector can generate.

When we designed our BioShares funds, we did not expect the recent wave of negative publicity and sentiment regarding the specialty pharma sector. However, we were convinced that biotechnology and specialty pharma are distinctly different, and our long term view on biotechnology led us to create the first ETFs that are 100% invested in that sector.

  1. Your BBC fund covers companies with drugs in clinical trials but no FDA approved drug, while BBP consists only of companies with at least one drug approved by the FDA. Why is it important to segment the biotech industry like this into two distinct parts? What are the implications of this for investors interested in Biotech?

Paul: Clinical-stage biotechnology companies and Product-stage biotechnology companies are so different that they almost merit different names. Clinical-stage companies, which spend hundreds of millions of dollars designing a molecule from scratch, testing it for more than a decade in the lab, then on animals and patients, are risky but potentially rewarding ventures. Product-stage companies have succeeded, beating the long odds of drug development, and are now in the business of selling these new breakthrough therapies to doctors and patients. The businesses in many ways could not be more dissimilar, and unsurprisingly their corresponding stock price characteristics are different as well.

We like to separate these two types of companies into different funds, with the clinical-stage stocks going into BBC, and the product-stage stocks going into BBP. The result is that the funds can be attractive to different investors with different risk-appetites and investment criteria. BBP includes stocks such as REGN, AMGN, ANAC and HALO and tends to be less volatile and large-cap oriented, and investors can track weekly prescriptions of new drug launches and quarterly financial results.  BBC includes stocks such as KITE, FPRX, FGEN and XLRN and investors focus more or clinical trial designs and results as well as corporate partnerships and balance sheets.

  1. Broadly speaking, what are the biggest potential threats on the horizon that could impede growth in the biotech sector? What are the most promising developments that could help lift the sector?

Paul: A public discussion on high drug prices continues to overhang stocks, but I believe that the government will continue to promote strong incentives for the biotechnology and drug industries to discover new, exciting medicines, while companies selling older medicines could suffer. As far as potential positive developments, the benefit of diversifying within the biotechnology space is that investors can gain exposure to many of today’s most promising areas of research including gene therapy and editing, companion diagnostics and personalized medicines, immunotherapies, Alzheimer’s research and rare diseases. While there can and will be setbacks within individual companies, disease areas or even entire technological approaches, the biotechnology sector is increasingly attracting the best and brightest from academia and large pharmaceutical companies and the opportunity set of diseases and approaches as well as financial resources of the biotechnology industry has never been richer.

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