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Could biotech boost your portfolio?

The ride to high returns through biotechnology can be quite unnerving.

Singularity University – a global community that uses exponential technologies to tackle the world’s biggest challenges – came to South Africa in October. The biotechnology component was fascinating, with massive implications for human health and longevity.

For investors, biotech could be a major factor to consider. The effect of longevity risk to retirement portfolios cannot be ignored. There are also some great investment opportunities in this asset class, but one needs to exercise extreme caution and invest with patience. Exponential innovation could result in affordable health care benefiting all stakeholders.

For now, however, I will focus on biotechnology as an investment asset class. While the Singularity University definition of biotechnology refers to the entire spectrum covering human health, animal health, agriculture and food innovation, the indices that cover biotech investments do not cover all the possibilities as per this definition. There is, therefore, a limitation to the tradeability of the full biotech spectrum using indexing.

Opinions on biotechnology as an investment class are polarised. Nicholas Taleb, in his book The Black Swan: The Impact of the Highly Improbable, refers to breakthrough biotechs as black swans and suggests that people invest equal amounts in each biotech share. Globally there more than 10 000 biotech firms, of which about 700 are actively traded. The financial outlay to exploit the full biotech universe on an equal basis is substantial. Others deem the risk to be too high, with the potential for total capital loss on too many of these biotech firms. There are also risks to established biotech firms in cases where adverse health events occur among consumers.

The graph below shows the returns of four different types of investments in biotech – one unit trust (Fidelity), one investment trust (Tekla), one equally weighted exchange-traded fund or ETF (Invesco), and one normal ETF (iShares). The table below the graph shows their performances and risk in more detail.

Source: Silicon Cloud Technologies

Source: Silicon Cloud Technologies

Biotechnology is undoubtedly a high-risk high-return investment opportunity. However, it also has some defensive characteristics, especially when you consider the healthcare segments of the biotechnology index. This is borne out by the positive correlations with the broader US market (ranging from around 0.5 to 0.7). Adjusted for inflation, the average return from biotech is around 11.6%, compared to the overall S&P 500 return of about 6.5%.

It is difficult to determine whether an index or active management style is superior as per the above table and graph. Adjusted for costs, there is not much separating an actively managed fund like the Fidelity biotech and the iShares Nasdaq biotech ETF. However, I wonder whether the biotech market has a high level of information efficiency. The research and development pipeline for new drugs can span many years, and investor-friendly information is not readily available during the development phases. None of the investors in this market are medically or scientifically qualified, and it is therefore possible that active funds might have access to expert knowledge that indexers would not necessarily have. Thus it is possible that active funds could out-run indexed investments in the biotech universe for a number of years.

Source: Visual Capitalist

The partial extract from a Visual Capitalist illustration shown above highlights the many opportunities for knowledgeable and well-researched active managers to outperform indexed investments. The visual also demonstrates the elongated drug development process and thus the need for patience to stay invested and capture outsized returns. The ride to high returns can be quite volatile and unnerving. It is for this reason that only high-risk tolerance investors should consider biotech as an opportunistic investment.

It was abundantly clear at the Singularity Summit that the biotech world is experiencing exponential innovation with profound implications for people and portfolios. Can investors ignore the opportunities that this scientific frontier will throw up in its revolutionary path?

Pragnesh Desai is CEO of Galileo Asset Managers.

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Biotech index has returned 0% for the last year (in $ terms). Just have a look what happened to the much loved and advertised FANG (Facebook, Amazon, Netflix and Google) stocks over the last couple of months – All fund managers are always great with historic performance and “back testing”.

Its pretty shocking how few Biotech companies actually become profitable. Just give something a fancy name and hope for the best!

Looking back at 11 years of returns (including the GFC) and comparing IBB (iShares BioTech) and VTI (Vanguard Total US Stock Market):
R2=0.43 (about 43% of changes in IBB is due to changes in VTI) – IBB has had a relatively low correlation with the market – good for diversification.
Beta: 0.89 – relative changes are less than those experienced by the market e.g. during the GFC VTI dropped by 50% but IBB about 25%.
Alpha (excess return after adjusting for risk) – 6.5% pa (significant at 80% confidence level)

Historically biotech has been a good investment offering diversification and superior risk adjusted returns relative to the US market. As an investor you have to ask whether this will continue or has something changed. There is an argument that society is aging and sick (preferably wealthy) people are willing to spend a lot of money to stay alive. On the other hand is ever increasing spending on health care sustainable in the long term and could regulation curtail this?

The burgeoning elderly population in the West and China will need care. I don’t think there will be much focus on technology to make people live longer. More likely the (crass) West will look at ways to shorten lives! An interesting aside is the prevalence of smoking. Smoking causes premature death. People who do not smoke often grow obese and in the non-smoking segment longevity is often associated with extended ill health. Very few live long healthy lives.

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