If you are betting that a cure for cancer will be found in your lifetime, investing in biotechnology exchange-traded funds, aka biotech ETFs, may be a way to capitalize on that idea. Biotechnology is a segment of the health care industry that primarily consists of companies that seek to find or produce biological treatments, pharmaceutical drugs, and diagnostic tools.
- Biotech ETFs may have higher risk-return profiles than broader market indexes
- Biotech ETFs could be a good fit for investors who can tolerate short-term market changes
- Investors must remember that sector-specific funds can increase risk (but also increase portfolio diversity)
What Are Biotech ETFs?
Biotech ETFs are exchange-traded funds that invest in stocks of companies within the biotechnology segment of the broader health care sector. Biotechnology companies typically employ the use of biological science and processes, such as genetic engineering, to produce pharmaceutical drugs.
As its name suggests, biotechnology combines the science of biology with technology. As in the process of genetic engineering, technology can be used to create or “engineer” biological molecules and to clone genes. Biotech firms may also work to identify genes or proteins that can be used to cure diseases.
Examples of biotech stocks include Seattle Genetics (SGEN) and Regeneron Pharmaceuticals, Inc (REGN).
Investing in the Biotech Sector
Biotech ETFs are often categorized as aggressive growth investments because they have the potential to have risk-and-return profiles that are greater than the broader market indexes, such as the S&P 500 Index. For this reason, it may be wise for investors who buy biotech ETFs to look for long-term growth of principal.
For example, as of Jan. 13, 2020, the S&P Biotechnology Index has returned a 10-year annualized average of 17.93%, while the S&P 500 Index has averaged 13.38% during that same time. Although historical returns have been higher for biotech ETFs than broader market index funds, the short-term performance can see greater volatility (greater swings in price up and down). For example, compare the same two indexes over a five-year period (2015-2020) and you’ll find that the S&P 500 Index actually had an annualized return of 12.09%, while the S&P Biotechnology Index averaged just 7.92%.
Like many other stocks, biotechnology stocks may have the potential to continue outperforming the broad market indexes because of advances in science and technology. And we may see this happen because of the second-largest demographic segment in the U.S.: the baby boomer generation, or those born between 1946 and 1964. As they age, pharmaceutical drugs and related products may remain in demand for the foreseeable future. Advances in biotechnology may also help to produce new drugs or related products with cures for diseases and ailments that come with this aging.
Who Are Biotech ETFs Right for?
When researching biotechnology ETFs, investors may want to look for funds that have low expense ratios, such as 0.50% or lower. Low expenses are especially important for ETFs because they almost always track an underlying index, such as the S&P Biotechnology Select Industry Index. Funds that passively track an underlying index and have low expense ratios will typically have superior long-term returns than those with higher expenses. A low expense ratio can help you save money and take home more from your investment.
Biotech ETFs may be right for buy-and-hold investors with a high tolerance for short-term market fluctuations. Buy-and-hold investors typically buy and hold investments for the long term and holding periods are often at least five to 10 years.
Short-term traders may also buy biotech ETFs for the purpose of making quick gains, then selling shares for profit. This type of buying is speculative (and therefore risky) because short-term price movement is difficult to predict.
Biotechnology ETFs and other sector funds can also be used to diversify a portfolio by adding exposure in a particular industry that is not already included in the portfolio. Sector funds can be wisely used as a diversification tool by allocating smaller percentages to a broad, diversified portfolio. For example, if an investor chooses to buy biotech ETFs, they may choose to allocate a smaller percentage, such as 5-10% of their portfolio, to riskier investments like these.
Although biotech stocks tend to carry more market risk than the overall stock market, diversification can help reduce a portfolio’s overall volatility.
The Bottom Line
Biotech ETFs may be smart investment choices for investors wanting exposure to stocks that have long-term growth potential. However, investors should keep in mind that investing in narrowly focused sector funds like biotech ETFs can increase risk. High relative market risk may increase the potential for greater long-term returns than a broad market index ETF can provide, but this risk is also associated with potentially greater volatility.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.