Don't Bail On Biotech ETFs: 'There Are Several Reasons Why The Sector Took A Breather'

The broader market scuffled in February, but the health care sector was worse. For example, the Health Care Select Sector SPDR XLV lost 4.5 percent, which was about 80 basis points worse than the S&P 500's February slide.

Biotechnology stocks and exchange traded funds were worse than the broader market and traditional health care funds last month. Just look at the iShares Nasdaq Biotechnology ETF IBB. IBB, the largest biotechnology ETF by assets, slipped 5.2 percent last month.

“There are several reasons as to why the sector took a breather,” Morningstar said in a recent note. “Valuations were part of it: Biotech stocks had such a good run for so long that valuations were stretched and some investors started taking profits. But two things had an even bigger impact on prices: politics and cycles.”

Favorable Demographics 

IBB holds 195 stocks, but the fund is primarily large-cap in focus. Gilead Sciences Inc. GILD, Amgen Inc. AMGN, Celegene Corp. CELG and Biogen Inc. BIIB are the ETF's four largest holdings, combining for about 30 percent of its weight.

Long-term fundamental factors bode well for the health care sector and biotech stocks.

For example, demographics in America — where the population is aging — and emerging-markets countries should keep business booming for the foreseeable future, according to Morningstar.

Still, investors are approaching IBB with caution, as highlighted by year-to-date outflows from the fund of nearly $800 million.

The M&A Catalyst

Mergers and acquisitions activity is often highlighted as a potential catalyst for biotech stocks. In January, there was about $25 billion in health care deal-making, half of 2017's total, indicating the sector's giants are eager to go shopping this year.

Bigger biotech companies, such as the ones dominating IBB's roster, are “certainly trying to increase revenues and share prices, especially via acquisitions,” according to Morningstar. 

With that in mind, investors looking for ETFs that have more potential biotech targets than acquirers may want to consider those funds with more mid- and small-cap exposure. That includes the SPDR S&P Biotech ETF XBI and the ALPS Medical Breakthroughs ETF SBIO. SBIO only holds companies with market values of $200 million to $5 billion.

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