Biotech ETFs: How to Choose the Right Fund for You

The world’s largest biotech and pharmaceutical companies are constantly racing to find new vaccines, treatments and cures, but the responsibility isn’t solely in the hands of household names like Johnson & Johnson and Pfizer. Dozens of smaller companies, often with highly specialized expertise, are also on the forefront of advanced research.

If you’re looking for a way to invest in these companies, how can you identify strong prospects? Investing in individual stocks always brings risks, but investing in biotech stocks can seem especially vexing to investors, given the complexities of the biotech product development process. There is, however, another option: biotech ETFs.

Biotech exchange-traded funds let you invest in a basket of health care companies through a single investment. These ETFs can be bought and sold throughout the day just like individual stock, but there’s a major difference between these products and stock shares: Buying shares of an ETF spreads your risk across a wide range of companies, so that the losses of the underperformers are offset by the gains of the outperformers. When buying individual stocks, you’re pinning all your hopes on the success of one company.

What’s more, these funds track indexes — meaning they invest in each of the stocks contained in a predefined area of the stock market — so you won’t pay a higher fee (commonly referred to as an ETF’s “expense ratio”) for a manager to pick and choose investments for you.

So when might investors seek out biotech ETFs, as opposed to broader ETFs or funds that track other sectors? Global health scares like the coronavirus pandemic in 2020 may bring to the fore biotech companies’ research, clinical trials, treatments and cures. That additional attention could influence consumer sentiment, and as both retail and institutional investors race to buy shares of companies that may benefit from a particular product development, the sector as a whole could see a lift in stock prices.

This trend appears to be holding true during the coronavirus-driven market volatility, with biotechnology stocks up 15% for the year as of July 7, compared to the S&P 500’s year-to-date return of -2.65%.

The companies ETFs invest in are called holdings. These may include some of the world’s most established and largest companies (think Johnson & Johnson or AstraZeneca) as well as smaller, less-experienced firms. But regardless of size, each will be assigned a specific “weight” in the ETF that determines how much the fund invests in a particular holding.

For example, shares of biopharmaceutical company Amgen Inc. make up (as of this writing) 8.46% of the iShares Nasdaq Biotechnology ETF — the largest holding in the fund, which tracks an index of biotech and pharmaceutical companies listed on the Nasdaq.

Compare this to the table below, which shows the largest holdings currently in the SPDR S&P Biotech ETF, which tracks the S&P Biotechnology Select Industry Index. Note that these weightings can change by the day — when a holding’s stock price changes, its market capitalization will rise or fall, thus impacting its percentage of the fund’s net assets.

Looking at an ETF’s holdings and their corresponding weights can help you determine if it’s the right fund for you.

Want to invest in smaller companies with a higher potential return in exchange for higher risk? There’s an ETF for that. Want to stick with the pharmaceutical giants with historically less volatility? There are plenty of those, too.

However, it’s important to note that sector ETFs are still often riskier than S&P 500 or total stock market ETFs — even the largest sector ETFs won’t offer the full diversification benefits of a broad market fund.

» Quick tip: If you know of a company or companies you’re interested in investing in, you could search for an ETF based on that particular holding using a stock exposure tool. For example, if you wanted to find all ETFs that invest in Moderna, just put in its stock ticker, MRNA, and the tool will display all ETFs that feature Moderna in their top holdings.

Some brokerages, like Vanguard, offer this tool for account holders. Take a look through our full list of brokerages for ETF investing, but keep in mind this tool may not be available at every brokerage.

When researching biotech ETFs, you can get a sense of their risk level by looking at their top 10 holdings, focusing primarily on those that are most heavily weighted. From there, take into consideration the market capitalization of these holdings. In general, companies with larger market caps often tend to be less volatile than those with smaller market caps.

The Virtus LifeSci Biotech Clinical Trials ETF, for example, invests in companies currently conducting clinical trials. Many of these companies are small- and mid-caps with high growth potential; currently, the fund has more than 130 such holdings. However, high growth potential also typically means high risk.

Below are eight global equity biotech ETFs with expense ratios below 1%, ranked by the average market cap of the companies held within the fund.

To explore the other end of the spectrum, let’s look at a broader ETF that focuses on larger health care companies and not just smaller biotechs: the Health Care Select Sector SPDR ETF, which invests in around 60 health care and pharmaceutical companies, some of which are among the largest in the world.

Once weighting is factored, a large portion of the fund is made up of just a few dominant players, noted below.

An ETF like this may not be heavily weighted in companies with enormous growth potential, but its focus on large-caps could give it relative stability and downside protection compared to an ETF with all small-cap companies. And if it’s the upside potential of small-cap ETFs you’re after, be sure to consider how that risk fits in with your overall portfolio, says Brett Koeppel, a certified financial planner with Eudaimonia Wealth in Buffalo, New York.

“In general, there will always be a trade-off between risk and return when evaluating the size of the companies an ETF holds,” says Koeppel. “While smaller market cap funds may have higher upside potential, you’ll want to ensure that the exposure you have is within a reasonable amount of your overall investment allocation as a whole.”

Here are the five largest global equity health care ETFs with expense ratios below 1%, ranked by average market cap, as of this writing.

To buy a biotech ETF, you’ll need a brokerage account. With low or zero account minimums, no trading fees and all-online transactions, many brokerage accounts are much more accessible than they used to be. Below are a few great brokerage options for buying an ETF:

Once you’re set with a brokerage account, determine if there are specific companies you’d like to invest in, whether that’s smaller, high-growth biotechs or larger, more established health care and pharmaceutical companies. This research will help you decide what your risk tolerance is and will point you in the right direction when you start looking at different ETFs.

Analyze the ETFs outlined in this article or run your own ETF screen through your online broker, and take a look through their holdings, which are clearly identified on a fund’s web page. Scroll through the holdings to see which companies the fund invests in and how heavily weighted each one is, or use a stock exposure tool to find ETFs that include a company you identified in your earlier research.