Biotech stocks have taken off since President Trump took office. For 2017, through the end of July, the iShares Biotech ETF (IBB), which tracks the Nasdaq Biotech Index, is up almost 19%, well ahead of broader market benchmarks. If you are thinking of investing in biotech stocks after this rally, here’s what you need to know.
Invest In The Benchmark?
The Nasdaq Biotechnology Index is a good benchmark for biotech managers but you can’t invest in it directly. That’s why the iShares Biotech ETF was created. IBB has a ticker symbol so you can easily invest in it, and it has expenses so it is a fair benchmark to compare a biotech manager against.
In order for a biotech manager to be a better choice than this ETF, the manager has to outperform this benchmark for long enough for us to have confidence in their skill, and by a large enough margin to make a difference for investors.
This table shows the short and long term performance of 3 of the largest Biotech mutual funds; Fidelity Select Biotech, Franklin Biotechnology, and T. Rowe Price Health Sciences. Lets take a close look at each of them.
T. Rowe Price Health Sciences
T. Rowe Price’s fund (PRHSX) did the best of the 3 mutual funds over the past 5 years besting the IBB 20.80% to 19.55%. This may not seem like a big difference, but it is rare for a mutual fund manager to beat his benchmark by 125 basis points a year for 5 years! Furthermore, earning an extra 1.25% a year, after all expenses, above the benchmark is enough to make a big difference for investors over the long term.
The problem I see is that the manager, Ziad Bakri, just started managing the fund on 04/01/2016. This means he is only responsible for the last 16 months of performance, not the last 5 years. The manager who was responsible for most of the fund’s impressive 5 year track record has moved on and will have no impact on your returns if you invest in the fund today.
If you invest today, Ziad Bakri is the manager whose skill you are depending on. And, after only 16 months, the track record is simply not yet long enough to provide confidence in his investment skill.
Fidelity Select Biotech
The manager of the Fidelity Select Biotech Fund (FBIOX), Rajiv Kaul, started on 10/12/2005. For the last 5 years, FBIOX outperformed the IBB 20.21% to 19.55%, an average of 66 basis points a year over the benchmark. Although the margin of difference is only about half of T. Rowe Price’s fund, Rajiv Kaul has been at the helm the whole time.
The extra 66 basis points of return is enough to provide some evidence of Mr. Kaul’s investment skill. The fact that he is also way ahead of the benchmark for YTD, 1 year, and 3 year returns increases confidence in his investment skill.
Is the 66 basis points enough to make a difference? It is if you are a long-term investor who will not be trading in and out of the fund.
The Franklin Biotechnology Fund (FBDIX) has lagged the IBB for the last 5 years, 18.54% to 19.55%, an average of 101 basis points a year. This, by itself, is a reason to prefer the IBB over FBDIX. But before reaching that conclusion, lets look at the fund’s managers.
The fund has 2 managers. Evan S. McCulloch has been a fund manager since 09/15/1997 and became the lead manager in 2000. Since the second manager, Steven Kornfeld, has only been a manager since 9/15/2015, it is unfair to blame him for the fund’s underperformance of the last 5 years.
McCulloch has been the lead manager for all of the last 5 years, but it is not clear whether the fund’s underperformance is attributable to him or to other managers who have come and gone over the years. It could be that McCulloch has done a great job of firing underperforming managers and the latest, Kornfeld, has not been there long enough to show proof of his investment skill.
One problem shared by all multi-manager funds is that you cannot use the fund’s track record to tell if the managers are skilled because you don’t know how much each manager contributed to the fund’s return.
However, since the fund has underperformed over 5 years, and also YTD 18.32% vs 19.66%, the evidence is not there to justify selecting this fund over the IBB.
When evaluating a manager, the longer the track record, and the bigger the alpha (performance above a benchmark) the more confident you can be that you’ve found a great one.
Todd Hagopian is a good example. Over the last 5 years, Todd’s biotech fund HIBEV averaged 26.41% beating IBB’s 19.55% by an extra 686 basis points a year. That’s a lot of alpha, enough to make a real difference for clients. That’s why I’ve allowed clients to invest in Todd’s HIBEV fund since about the middle of last year after the track record had turned 5. Todd’s HIBEV model is up 38.26% YTD, and the composite of clients who have invested in this portfolio is up 36.85%.