In 2021, the outbreak of the COVID-19 pandemic made biotech stocks one of the hot symbols that attracted investors' attention.

However, as the pandemic gradually subsided, the stock prices of biotech companies continued to decline. According to IBD reports, from the beginning of 2021 to October 2023, the ETF tracking biotech stocks, XBI, fell by more than 60%.

In the last two months of 2023, biotech stocks finally saw a rebound, with XBI rising more than 40%. Wall Street analysts stated that 2024 could be a breakout year for biotech stocks.

So, are biotech stocks worth investing in? What factors need to be considered when making an investment?

This article will provide an in-depth introduction to the biotech industry and its characteristics, and explore whether it is worth investing in; it will also introduce several indices that track the performance of biotech companies and related ETFs. It is hoped that this article will help those interested in investing in the biotech stock sector.

After reading this article, you will gain the following insights:

1. What are biotech stocks? What characteristics do they have?

2. Is it worth investing in biotech stocks?

3. What indices track biotechnology companies?

4. Analyzing the pros and cons of the three major biotechnology indices.

What are biotechnology stocks? What characteristics do they have?

Biotechnology companies (Biotech) are actually a type of pharmaceutical company, belonging to a subfield within the Medical Industry.

Generally speaking, biotechnology companies have the following three characteristics:

1. High investment with a long wait: It may take up to ten years to bring a new drug from the lab to the pharmacy shelves. During this period, biotechnology companies may not be profitable and rely heavily on venture capital funds or being listed on exchanges to secure funding for research and development.

2. High risk: Developing new drugs is an expensive, slow, and high-risk endeavor, with a very high risk of failure. According to Historical Data, approximately 85% to 95% of new drugs fail to gain approval. Many biotechnology companies suffer significant losses after critical research or drug trials fail.

3. High returns: During the research phase, biotechnology companies typically do not make profits; however, once breakthrough drug research succeeds, they can achieve huge profits and protect their designs through intellectual property rights or copyright to prevent competitors from imitating.

It is necessary to explain here that many investors are confused about the distinction between biotechnology (Biotech) and pharmaceutical companies (Pharm); in fact, they all fall under the category of pharmaceutical companies.

From the nature of the business, Biotech companies develop drugs using living organisms, while Pharm develops drugs using chemicals. However, over time, this distinction is not so strict; in other words, a biotech company can also be a Pharm company, and vice versa.

However, from the financial characteristics, there are significant differences between Biotech and Pharm. Generally speaking, Biotech companies are mostly small and medium-sized enterprises, and their financial characteristics resemble those of technology stocks. For example, Moderna (MRNA), which attracted significant attention during the pandemic, has a stock price that can fluctuate drastically due to the development of a single drug, and cash flow is unstable; although the stock price may soar quickly, it can also fall just as fast. Due to high expectations for new drugs, a company may still be in a loss situation while its stock price could reach new highs.

In contrast, Pharm typically refers to larger pharmaceutical companies, which are also known as Big Pharm, representing companies such as Johnson & Johnson (JNJ), Pfizer (PFE), and so on. These companies have more stable cash flows, and their stock prices are not easily affected by the development of a single drug, leading to significant volatility. Their primary source of profit comes from drugs that are still under patent protection, and they need to invest large amounts of money each year into new drug research and development. In addition to pharmaceutical business, these companies are usually also involved in other fields such as medical devices and healthcare.

What are the influencing factors for biotechnology stocks?

Many investors are interested in biotechnology stocks because this industry has a rare ability to turn an ordinary small company into a multi-billion dollar market cap overnight.

The key factors determining the stock price trends of these biotechnology companies are the results of new drug clinical trials and the approval of the U.S. Food and Drug Administration (FDA).

Generally, small and medium-sized biotechnology companies only develop two to three products, requiring significant research and development funding support in the early stages. If the clinical trial results are favorable or the new drug receives FDA approval, it may lead to a surge in stock prices; on the contrary, if the clinical testing is unsatisfactory or the new drug is not approved, there is a risk of stock price plummet.

Therefore, when betting on a particular biopharmaceutical company, while there may be excess returns, there are also potential risks of devastating losses.

However, from the perspective of the entire Industry, the factors affecting the overall trend of the Sector are more complex. Wall Street Institutions believe that investor interest in the biotechnology Industry may be warming up, with three main potential driving factors:

Interest Rate Cut Expectations: As many biotechnology companies rely on financing for new drug development, borrowing costs have become a critical consideration in company Operations. In recent years, the Federal Reserve's consecutive interest rate hikes have put pressure on biotechnology companies, but Leerink Partners analysts state that as we enter 2023, the Federal Reserve is cautious about further rate hikes, and the market generally expects potential interest rate cuts in the future, which is expected to relieve the financing pressure faced by biotechnology companies.

Increased Mergers and Acquisitions: Mergers and acquisitions frequently occur in the Medical Industry, typically involving large pharmaceutical companies acquiring small and medium-sized companies, primarily to expand scale to improve efficiency and acquire new markets, products, and talent. RBC's report believes that increased M&A activity has a positive effect on the valuation of small and medium-sized pharmaceutical companies and can also strengthen the fundamentals of large pharmaceutical companies, creating a win-win scenario. Additionally, a report by PwC indicates that as pharmaceutical companies become more familiar with new regulations, larger-scale merger activities are expected in 2024.

Technological Innovation: Analysts also believe that certain companies will have strong prospects in 2024 in the fields of targeted oncology, immunology, and metabolism.

It should be noted that the above three factors may affect the trends of the biotechnology Industry from the aspects of company Operations, valuation, and technology; in the long run, whether a company or an Industry's value grows or not still depends on whether its profits can increase.

Which indices track biotechnology companies?

Investors can track the overall trend of biotechnology companies through industry indices.

However, with the development of the Industry, there are more and more indices tracking biotechnology companies. According to a report by NYSE, as of March 2023, the global assets of funds tracking biotechnology indices have reached 54 billion USD.

Among the indices tracked by these Funds, the top three ranked by asset size are the Nasdaq Biotechnology Index, the SPDR S&P Biotech ETF, and the ICE Biotechnology Index.

Since these indices are compiled in different ways, their constituent stocks and characteristics also vary. Here is a brief introduction:

SPDR S&P Biotech ETF (SPSIBI)

The SPDR S&P Biotech ETF (S&P Biotechnology Select Industry Index, symbol SPSIBI) was launched in January 2006, and this index mainly tracks biotechnology companies classified under the GICS industry classification standard. These companies include biotechnology stocks listed on all major Exchanges in the United States.

This index is constructed using a Modified Equal Weighted method, meaning that regardless of market cap size, each constituent stock in the index has the same weight. The benefit of this approach is that the influence of mid and small-cap stocks on the index is also significant.

As of December 29, 2023, this index has a total of 120 constituent stocks, with the top ten constituents accounting for 16.3% of the weight.

According to data from ETF Database, among the ETFs tracking the SPSIBI Index, the largest in terms of assets is XBI (SPDR S&P Biotech ETF).

• Weighted method: adjusted equal weight.

• Number of constituent stocks: 120.

• The top ten constituent stocks account for 16.3%.

• Related ETF: XBI.

*The data for this index is sourced from the S&P Biotechnology Select Sector Index Factsheet, data as of December 29, 2023. The related ETF is ranked first in asset size tracking this index as shown on ETF Database.

Nasdaq Biotechnology Index (NBI).

The Nasdaq Biotechnology Index (Nasdaq Biotechnology Index, symbol NBI) was launched in 1993. It primarily tracks biotechnology companies listed on the Nasdaq market under the ICB industry classification. However, it is worth mentioning that the index not only includes biotechnology companies but also includes a few pharmaceutical companies.

This index uses a modified market capitalization weighting method for its compilation. In other words, the larger the company's market cap, the greater its price change impact on the index. However, unlike a regular market capitalization weighting, the modified market capitalization weighting rebalances weights each quarter, with a cap of 8% (for the top 5) and 4% (for the others) for constituent stocks, preventing major companies from having too much influence on the index.

As of December 29, 2023, the index has a total of 225 constituent stocks, with Vertex Pharmaceuticals (VRTX) being the largest weighted constituent, accounting for 8.5%, and the top ten constituents collectively accounting for 50.41%.

According to ETF Database data, the ETF tracking the NBI index with the largest asset size is BIB (ProShares Ultra Nasdaq Biotechnology). It should be noted that BIB is a leveraged ETF, and its fluctuations are about twice that of the index's daily movements, accompanied by higher risk.

• Weighting method: adjusted market cap weighting.

• Number of constituents: 225.

• Percentage of top ten constituents: 50.41%.

• Related ETF: BIB.

*The data for this index is sourced from the NASDAQ Biotechnology Factsheet, with data as of December 29, 2023. The related ETF is the one ranked first in asset size tracking this index from ETF Database.

ICE Biotechnology Index (ICEBIO).

The ICE Biotechnology Index (ICE Biotechnology Index, symbol ICEBIO) primarily tracks biotechnology companies classified under the ICE industry classification standard. These companies include biotech stocks listed on all major Exchanges in the United States. Notably, on November 3, 2023, the ICE Biotechnology Index was renamed the NYSE Biotechnology Index.

The index is compiled using a modified float-adjusted market capitalization-weighted method, which includes two adjustments based on market cap weighting: first, using float-adjusted market cap instead of total market cap; second, adjusting each quarter.

Since the Factsheet for the index does not provide relevant information about its constituent stocks, more details can be obtained from the ETFs that track the index.

According to the ETF Database, the largest ETF tracking the ICE Biotechnology Index by Assets is IBB (iShares Biotechnology ETF).

As of December 31, 2023, IBB contains a total of 227 constituent stocks, with the largest weight being Vertex (VERX), and the top ten constituents account for 50.38% of the weight.

• Weighting method: adjusted float-adjusted market capitalization weight.

• Constituent stocks: 227.

• Top ten constituent stocks account for: 50.38%.

• Related ETF: IBB

*The data for this index comes from the ICE Biotechnology Index Factsheet and the IBB Factsheet, with data as of December 31, 2023. The relevant ETF is ranked first in terms of asset size tracking this index according to ETF Database.

Advantages and disadvantages of the three major biotechnology indices.

Some investors may ask how to choose among so many biotechnology industry indices.

We can analyze the advantages and disadvantages of the indices from three aspects:

First, we can look at the weighting method. Both NBI and ICEBIO are market cap weighted indices, so large-cap stocks have a significant impact on the index. In contrast, SPSIBI is an equal-weight index, where small and mid-cap stocks are as important as large-cap stocks, making it more advantageous in reflecting the trends of small and mid-cap biotechnology stocks.

Second, we can look at the constituent stocks. Although NBI and ICEBIO use the same weighting method, the differences in sector classification standards result in differences in constituent stocks. Moreover, ICEBIO and SPSIBI are relatively pure in terms of sectors, tracking only biotechnology stocks, while NBI includes a small number of pharmaceutical companies in addition to biotechnology companies. In terms of listed markets, NBI only tracks Nasdaq-listed companies, while ICEBIO and SPSIBI include biotechnology stocks listed on all major exchanges in the United States, making them more comprehensive.

Finally, we can look at historical trends. According to a report from the NYSE, in terms of annual index trends, SPSIBI is more volatile compared to the other two indices. Between 2013 and 2022, SPSIBI either performed the best or the worst. The index ranked first in annual returns for six years and last for four years. Over the long term, ICEBIO has performed better. In the past 3, 5, and 10 years, the total returns of ICEBIO were 5.18%, 6.33%, and 12.61%, respectively, all outperforming the other two indices.

*Past performance does not indicate future results, the market has risks, and investments should be approached with caution.

In summary

• Biotechnology is a sub-sector of the medical healthcare sector, characterized by high investment, high risk, and high returns; its stocks resemble technology stocks more than those of pharmaceutical companies.

• Factors influencing biotechnology stocks include clinical trial results, FDA approvals, expectations for interest rate cuts, increased mergers and acquisitions, and technological innovations.

• Indices for biotechnology companies include the Nasdaq Biotechnology Index, the S&P Biotechnology Select Sector Index, and the ICE Biotechnology Index.

• When selecting biotechnology indices, the weighting method, constituent stocks, and historical trends should be considered. Over the past 10 years, the ICEBIO has performed better.