Street Talk: Biopharm Exchange-Traded Funds: Their Time has Come

On a recent plane ride from Phoenix to Philly, I was leafing through a copy of the San Francisco Business Journal. I was taken aback by a story on the emerging trend of biopharm exchange-traded funds (ETFs), and how much of an impact they're having on Wall Street and on investors.

Brian O'Connell

The story opened with this clever gambit: "Bill Kridel wants to give you exposure to cancer and only cancer, if that's what you want. If neurodegenerative disease is more your speed, or cardiovascular disease is what you're in the market for, he thinks you should have that choice. Or, if you prefer, get them all."

Kridel is well known on Wall Street, and also in executive boardrooms at big biopharm companies across the globe. He is the founder of the investment banking firm Ferghana Partners, a big player in life science mergers and acquisitions, divestitures, and private placements.

So it's not cancer that Kridel is happily spreading, it's the chance to invest in an exchange-traded fund chock full of companies engaged in the fight against cancer—and to profit handsomely by doing so.

THE ETF ERA

Kridel is hardly alone. A burgeoning number of biopharm-based ETFs are popping up on the landscape, offering the opportunity to climb on the backs of companies fighting infectious diseases or respiratory pulmonary diseases. Currently, among the top life sciences ETFs (in terms of investment) are SPDR Biotech ETF (XBI), PowerShares Dynamic Biotech & Genome (PBE), IShares NASDAQ Biotechnology (IBB), First Trust AMEX Biotechnology (FBT), and the Biotech HOLDRs (BBH). Some of the funds hold as few as 20 biopharma stocks and some hold 200, and each offer their own risk–reward ratio. I'll leave the performance issue to another column.

The question I pose today is, Why ETFs at all?

First, I like what the ETF community is offering. Exchange-traded funds may be the one exception to an old rule—that new investment products cooked up by Wall Street's "rocket scientists" help them make money more than they help you.

How do they work? Simple. Take a mutual fund and trade it on a stock exchange, and you have an exchange-traded fund, or ETF. While ETFs contain at least dozens and sometimes thousands of individual securities, you still buy or sell them as a single unit, just like individual stocks. ETFs often make more sense than mutual funds for short-term trades and for very-long-term investments.

An ETF is a basket of securities that is designed to track an index—a broad stock or bond market, industry sector, or international stock market, ranging from the widely known, such as Standard & Poor's 500-stock index, to the virtually unheard of, such as the Dow Jones US Basic Materials Sector index. Since 1993, when the American Exchange ("the Amex") began trading Standard & Poor's Depositary Receipts, which track the S&P 500, ETFs have grown in number and diversity. These funds are traded like stocks, with the majority of them listed on the Amex.

The underlying markets of ETFs, however, are more similar to stock index futures and index mutual funds, which makes them more comparable to these products rather than to stocks. From a trading standpoint, ETFs have numerous benefits over mutual funds (Table 1), and depending on your goals and style, ETFs might be the best instrument available.

ETFs are very user friendly. You don't need to learn the fine points of how ETFs operate to use them. In essence, an ETF's sponsor buys stocks or bonds in the proper quantities to build baskets of securities that reflect an index. The sponsor then sells the ETF on the stock market. Individual and institutional investors buy shares of the ETF from the sponsor and from one another.

Because they trade like stocks, ETFs give investors more flexibility than regular mutual funds. You can buy and sell them anytime during the trading day, not just at the market's close, as is the case with the overwhelming majority of mutual funds. You can sell an ETF short—that is, make a bet that it will decline in price. You can buy ETFs "on margin," in other words, by borrowing from your broker.

Investors often like ETFs because they can put stop-loss orders under them, just as you can with ordinary stocks. Let's say you're bullish on cancer research companies but fear getting stuck with too many investments in the sector if it falls too far. You can buy cancer-company-based ETFs with a stop-loss that instructs your broker to automatically sell the ETFs if they drop 10%.

COMPARING ETFs WITH INDEX MUTUAL FUNDS

You may wonder, Aren't ETFs exactly like index funds? It's a fair question. It's true that that the differences between ETFs and index funds are not huge. But ETFs have benefits over mutual funds for almost every category important to traders (Table 1).

Table 1. A comparison of exchange-traded funds and mutual funds

How those benefits stack up depends on what type of investor you are. If you've been an index-fund investor for years—particularly if you've already built up substantial unrealized capital gains—the last thing you want to do is sell your index funds and buy ETFs. Stick with what you've been doing.

Buying an ETF or a portfolio of ETFs makes the most sense if you have a brokerage account and like the idea of consolidating your assets in one account. But keep in mind that you pay more than just the rock-bottom expense ratio when you buy and sell ETFs. You also pay a brokerage commission and the (usually small) difference between the bid–asked spread on the ETF. Investors putting a substantial sum in an index at one time will likely end up paying less with an ETF. Those investing small amounts, particularly on a regular basis, will do better with index mutual funds.

For truly long-term investors who plan to hold an index fund for at least ten years, ETFs hold a clear advantage. Why? Because they rarely pay out taxable capital gains. ETFs' tax efficiency saves mere pennies in taxes when you hold a fund a year, or even five years. But over longer periods, ETFs may be a better way to shield capital gains from the tax man than IRAs and other tax-deferred vehicles. That's because when you cash out of IRAs, you're taxed on your gains at your ordinary income-tax rate, which is much higher than the capital-gains tax rate, unless you have only a tiny income.

So behold the dawn of a new era on Wall Street, and in the life sciences industry. A new, more flexible, more management fee- and tax-friendly way to invest in biopharm companies has arrived, with no discernable differences in performance than mutual funds.

Where do I sign up?

Celebrity author and business/finance commentator for CNN and Fox News, Brian O'Connell has written for The Wall Street Journal and Newsweek. He can be reached at 267.880.3144, brian.oco@verizon.net