Despite recent pullbacks, exchange-traded funds in the biotech sector continue to outperform the market.

The S&P 500 has lost 32% year to date. While the major biotech ETFs have faced resistance, their performance has been nowhere close to that experienced by the broader market indices. So far this year the SPDR Biotech ETF ( XBI) and the iShares Nasdaq Biotechnology Fund ( IBB) are down only 9.7% and 11.6%, respectively. The Biotech HOLDRS Trust ( BBH) is actually up 0.3% year to date.

The relative strength of biotech ETFs has not gone unnoticed by money managers. "We had a buy signal in the spring on biotech," said Jim Porter, portfolio manager of the Aston/New Century Absolute Return ETF Fund ( ANENX). "It has substantially outperformed the Russell 3000."

Porter acknowledges that biotech is not in the clear just yet. "The sector has traded sideways since the middle of September," he said. "Venture capital is going to become more and more careful where it invests its money and is going to want larger ownership interests."

A Focused Approach

As of Aug. 31, the SPDR Biotech ETF, or XBI, was one of Porter's top 10 holdings. XBI has $543 million in total assets, which are spread across 22 holdings. Vertex Pharmaceuticals ( VRTX), OSI Pharmaceuticals ( OSIP) and ImClone Systems ( IMCL) are among the top names in the fund's portfolio.

The iShares Nasdaq Biotech Fund, or IBB, presents a fairly balanced attack with 147 holdings. In recent weeks, it has faced adversity similar to that of the market. "We recently turned negative on it," said Philip Yockey, president and chief investment officer of Tactical Analytics, an independent private research company. "Once it broke under $80, they crushed it like a grape. You have to be careful if it doesn't hold above $69."

The Biotech HOLDRS Trust, or BBH, takes a more focused approach with only 12 holdings. Genentech ( DNA), Affymetrix ( AFFX) and Gilead Sciences ( GILD) account for more than 80% this fund's weight. "It's not as cheap as IBB," Yockey said.

Immune to the Storm

Each of these three ETFs has trended downward in recent weeks. "The market decline has destroyed value in all industries," said Hamed Khorsand, an analyst with BWS Financial. "As of late, the market has been in a liquidation mode."

Despite this slump, Khorsand believes that there are areas within biotech that are better positioned to fend off hard times. "Large-cap biotech companies are more immune to these macroeconomic trends," he said. "It's the small-cap companies that are more dependent on access to capital."

Prior cycles also lead Khorsand to the conclusion that there is plenty of upside potential in the sector going forward. "When there is softness in the economy, one area that usually holds up well is biotech," he said. "I think that is likely to be the case again over the next year or so."

Seeing Value

Investors who are looking to break down these ETFs to trade on the individual names or are just scanning the biotech sector for candidates with upside potential have plenty of options. One name that Porter likes in particular is Techne ( TECH). In August, the biological products company reported fourth-quarter results that included a 20.7% rise in diluted earnings per share on a 16% spike in net sales over the same quarter a year ago. "The stock has a nice trend going since June of last year," he said.

The markets' distress has left some biotech stocks trading at prices that Khorsand views as prime buying opportunities. Three stocks that he likes right now all are among the top 15 holdings of XBI. Cephalon ( CEPH), Biogen Idec ( BIIB) and Gilead are at the top of his list. "There is a lot of value in these three companies right now," he said. "They are all revenue generating, profitable names."

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