By Marek Poszepczynski and Ailsa Craig, co-investment managers of the International Biotechnology Trust
Given the complexity of the biotechnology industry, it is unsurprising many investors new to the sector seem to invest via exchange traded funds (ETFs), which provide broad exposure to the leading names in the space. However, index-tracking investors were burned last year when the pandemic rally came to an end and the whole sector suffered from a sell-off.
With market swings common in this space, we believe new investors should consider vehicles that offer active in-depth stock selection. These strategies can permit investors to capitalise on upward movements and minimise losses during downturns, while mitigating volatility over the long term.
Balance is best
Presently, the four largest companies in the NASDAQ Biotechnology Index – one of the most recognised biotech indices, home to more than 300 global companies – have stalling revenue growth over the next few years. Despite this, they make up a significant proportion of the benchmark.
This could be problematic for ETF investors, given stock weightings for index trackers are to a large degree governed by their market capitalisation and cannot be adjusted to consider changes in market conditions. Last year, on the back of its Covid-19 vaccine breakthrough, Moderna alone reached a valuation of more than $200bn and made up an outsized position of the entire index, before falling back 70% in under a year to now constituting less than 4%. This is without a major correction in the company’s perceived fundamentals.
Sizeable valuation swings are characteristic of the biotechnology space, as investment in the sector is at times sentiment driven. New announcements of revolutionary treatments often fuel overly optimistic expectations of future cures, which trigger hype and an influx of investment that usually fade once a more realistic picture of the treatment emerges. Additionally, investors tend to dip in and out of the sector depending on their risk appetite.
As such, an active strategy provides investors with the flexibility to ensure their biotech exposure is well balanced and no one stock or type of stock becomes too dominant. This is key for insulating against the sector’s pronounced investment cyclicality.
Tapping scientific potential
Investing in an actively managed fund provides access to biotech professionals with extensive sector expertise. Scientifically and medically trained fund managers are best placed to understand and identify the underlying potential in companies, as the science behind a company’s pipeline of innovation is fundamental to its success.
When constructing portfolios, we conduct an extensive review of the macro environment, company constitution and management capabilities, while also weighing fundamental scientific analysis, including the interpretation of clinical trial data. This well-rounded picture is critical to identifying companies unfairly derated by the market – or those with inflated valuations that are no longer justified.
Recently, rising macroeconomic headwinds, as well as the diminishing focus on Covid-19, have increased the appeal of less risky investments and knocked sentiment in the biotech space. However, this provides the opportunity for active, valuation-focused investors with staying power to invest in future winners at what we consider to be highly attractive prices.
We have taken advantage of reduced valuations in the sector to top up stocks we already own and invest in exciting innovations we previously felt were overpriced.
An additional benefit of opting for an active strategy is it provides investors with a choice of fund structure. All passively managed and most actively managed funds are open ended, meaning the fund continues to expand as new investors join and shrinks when investors withdraw assets.
While one advantage of this is the fund can grow quickly, which may lead to reduced fees per investor, this structure may force managers to buy assets when investment attention is highest, potentially at inflated prices. In fact, a fast growing passively managed fund can quickly become one of the largest investors in an index’s smallest companies, which may have the impact of fuelling valuations through technical money inflows. Also, if markets slump and investors rush to withdraw cash, a neat exit becomes difficult to achieve at the smaller cap end of the spectrum, which can result in forced sales at low valuations. To counter this, open ended funds will often hold higher levels of cash, which can drag on performance in rising markets.
Alternatively, investors can opt for closed-ended investment trusts. Rather than buying a unit in a fund, investors purchase a share in an investment trust company, where the trust’s assets are simply the investments it owns. The trust, which is listed on the stock exchange, trades at a discount or premium to the trust’s net asset value based on supply and demand. This structure means closed-ended funds are neither forced buyers nor forced sellers of stocks. If investors wish to sell their holding, they must find a buyer for their shares through the stock exchange and may have to sell at a discount to the net asset value.
Investment trusts also have other advantages – they can leverage debt to improve returns when markets are rising, choose to pay dividends from capital, and invest in less liquid assets, such as private companies. Accessing private companies is particularly important for biotech investors because of the potential for significant returns from early-stage innovators, which are frequently acquired by larger players seeking new sources of revenue. Just under 10% of our portfolio is invested in otherwise inaccessible, less liquid early-stage venture assets.
In rising markets, comparing an open-ended fund with a cash drag against a geared closed ended fund can show a notable divergence in performance. In falling markets, the reverse can also be true, but we take a tactical approach to gearing in order to attempt to mitigate this risk.