Biotech Breakout Highlights Flawed ETF Thinking

After a shallow, and it should be emphasized it was quite shallow, pullback last month, the biotechnology sector is flexing its muscles once again.

The other thing that is shallow is how many folks, including professional investors, view the biotech sector by way of ETFs.

There is ample talk of the sector hitting fresh, all-time highs on Wednesday and again today. However, when it comes to biotech ETFs, the conversation continues to revolve around one fund: The iShares Nasdaq Biotechnology ETF IBB.

Related: Biotech Breakout Boosting ETFs.

Before going any further, one thing needs to be made clear: This is not a hit piece on IBB. Entering Thursday, the largest biotech ETF was up 46.8 percent year-to-date. IBB is large; $3.7 billion in assets says as much, liquid, has options trading on it and has been deservedly praised in this space in the past.

However, if the biotech ETF race were an Olympic event, to this point in 2013 IBB would merely be the bronze medal winner. Since there are five biotech ETFs, being in third place puts IBB right in the middle. To be fair, that is not a bad place to be with this particular this year. An almost 47 percent gain for a sector ETF that is third-best ETF in that group is a testament to the sector's strength.

It is also a testament to the dire need for more traders and investors to learn more about ETFs, mainly that bigger is not always better with ETFs.

Unfortunately, biotech ETFs stand as a prime example of the flawed assumption that bigger is better. Look at all the love IBB is getting on StockTwits and other reputable sources of information on financial markets.

What no one seems to want to tell investors is that on a year-to-date basis, the PowerShares Dynamic Biotechnology & Genome Portfolio PBE has outpaced IBB by 310 basis points. The Market Vectors Biotechnology ETF BBH has been even better, gaining 50.4 percent this year.

Morningstar advocates IBB's market cap-weighted approach, saying "Unlike several other competing biotech ETFs that track equal-weight indexes, this fund tracks a market-cap-weighted index, which ensures that the more established, larger-cap biotech firms hold more sway," according to MarketWatch.

One way of interpreting that statement is that investors that want ample exposure to the biotech "big four" – Amgen AMGN, Celgene CELG, Gilead GILD and Biogen BIIB – should prefer IBB. It is not bad advice when considering that quartet combines for just over 32 percent of IBB's weight. However, if the objective is to milk the big four for all they are worth, than BBH makes more sense because it devotes 35.4 percent of its weight to those names, according to Market Vectors data.

Importantly, BBH outpacing IBB is not something that started this year. Over the past year, BBH is up 59.6 percent compared to 49.3 percent for IBB. Surely, there is something to be said for volatility, as Morningstar noted, but on a risk-adjusted basis, the BBH is still the winner as it was barely more than 100 basis points more volatile than IBB over the past 12 months.

Simple math dictates taking on, say, 150 basis points in added volatility to gain over 1,000 basis point in out-performance is a good trade. Noteworthy is the two-year returns where BBH has outpaced IBB by 1,580 basis points while only being 50 basis points more volatile.

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