Biotech Goes Mainstream

A new exchange-traded fund focusing on biotech stocks will begin trading on the American Stock Exchange Friday, even though some fund watchers question whether now's the best time to delve into the sector.

The new ETF, the iShares Nasdaq Biotechnology Index Fund, will track the Nasdaq-traded companies that are engaged primarily in using biomedical research for the discovery or development of novel treatments and cures for human disease. The launch marks the second exchange-traded product to track the biotech industry, the first being the (BBH Quote)Biotech Holdrs, or Holding Company Depositary Receipts, which debuted in late 1999.

The new fund, which will trade under the ticker symbol IBB, is also the second ETF to be based on a Nasdaq index, following the wildly popular (QQQ Quote)Nasdaq-100 Index Tracking Stock, which accounted for much of the trading volume and assets on the Amex last year.

Barclay's Global Investors, which sells the iShares, is hoping the new product will repeat the success of the QQQ, and the firm even held a press conference with the Nasdaq to ring in its inauguration. But the narrow focus of the fund, along with the some of the sky-high valuations of many Nasdaq-traded biotech companies, might make some investors skittish, says Morningstar senior editorial analyst Peter Di Teresa.

Although the Nasdaq biotech index is down some 7% so far this year after rising 23% in 2000, Di Teresa notes that the price-to-earnings ratios of many biotech companies in the index are still extremely high.

"I've certainly talked with active managers on the biotech side, and they did see some buying opportunities," says Di Teresa. "But we're still talking about some very, very high multiples."

For example, the biotech index's largest component, Amgen (AMGN Quote), has a P/E ratio of 67 times trailing earnings and recently traded at 69 13/16, at the upper end of its 52-week range of 50 to 80 7/16. Another company in the index, Chiron (CHIR Quote), trades at a P/E ratio of 397 times trailing earnings.

While the run-up over the past few years has been extensive, other analysts note that there will always be investors who want exposure to red-hot sectors no matter what the cost.

On a Roll The performance of the Nasdaq Biotechnology Index (IXBT) vs. the Nasdaq 100 over the last two years

Source: Nasdaq

"I think it's going to be very, very popular, just because of the run-up in biotech," says Salomon Smith Barney ETF analyst Kevin McNally. "You know how investors always get in at the top."

Performance aside, many agree that the launch of a biotech ETF is long overdue. Lee Kranefuss, chief executive officer of Barclays Global Investors' Individual Investor Group, says the firm has been eager to launch a biotech ETF for some time, but regulatory hurdles and other administrative details have held up the process.

The Biotech Holdrs, which are among Merrill Lynch's most popular baskets of stocks, had been the sole exchange-traded vehicle for biotech stocks, but analysts note that there are some inherent limitations in the product. The Holdrs simply invested in the 20 largest and most liquid biotech stocks on the market at the time the fund was formed, while the Nasdaq biotech ETF is more diversified, with 76 companies.

The ETF also rebalances twice a year based on market data, while Holdrs carry the same stocks until one is nudged out because of a corporate event, like a merger. Because another stock would not replace the exiting company, investors could eventually find themselves holding an even more focused fund years down the road with the Holdrs.

That said, the Nasdaq Biotech index is rather concentrated in a few names, as well. As of the market's close on Wednesday, the index had a 32.6% weighting in Amgen, with its second-largest holding a much smaller 7.3% weighting in Immunex (IMNX Quote) (Biotech Holdrs' most recent largest weighting was a 21.5% stake in Amgen and a 17.5% stake in New York Stock Exchange-listed Genentech (DNA Quote)). Morningstar's Di Teresa says the Nasdaq ETF's concentration is the inevitable consequence of a fund that tracks an index based on market capitalization.

"The trade-off is that some actively managed funds may focus more on some of the more up-and-coming companies," says Di Teresa. "But that's a classic trade-off between indexed and actively managed funds. That's not specific to this fund."

The other side of that trade-off is the low expense ratios of ETFs compared with those of their actively managed brethren. The expense ratio of the new biotech ETF is 0.50%, in line with that of other exchange-traded funds, notes Di Teresa.