In 2021, the biotech sector received a considerable uplift due to the COVID-19 pandemic, yet the ensuing two years saw a downturn in stock prices.

Nevertheless, a resurgence occurred in late 2023, prompting analysts to predict a potentially explosive growth for the sector in 2024.

This article explores whether it is worth investing in biotech stocks and introduces the leading biotechnology indexes in the U.S., as well as ETFs to invest in them.

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

1. the characteristics of biotech stocks;

2. the investment potential of biotech stocks;

3. Indexes for tracking biotech companies;

4. Pros and cons of the three major biotech indexes.

What are biotech stocks?

Biotech stocks represent companies within a specialized sector of the healthcare industry, focusing on drug development through biological processes. These firms are distinguished by three key traits:

1. Significant investment and extended development cycles: The journey from lab to pharmacy can span a decade for new drugs, with many biotech companies operating at a loss during this period. They depend on venture capital and public markets to fund their extensive research and development efforts.

2. High risk: The path to creating new drugs is fraught with financial risk and high failure rates—between 85% to 95%. Such daunting odds mean that biotechs can incur hefty losses if their research or clinical trials don't pan out.

3. High returns: Despite the risks and initial lack of profitability, successful biotech firms that innovate breakthrough drugs can realize significant profits and maintain a competitive edge by safeguarding their intellectual property.

It's common for investors to mix up biotech with pharmaceutical companies.

Traditionally, biotech firms harness living organisms to create drugs, while pharmaceutical companies rely on chemical processes. Over time, these lines have blurred, allowing companies to operate across both domains.

However, from a financial perspective, there are significant differences between biotech and pharmaceutical companies. Generally speaking, biotech companies resemble technology stocks in terms of their financial characteristics. For instance, Moderna (MRNA), which has garnered considerable attention during the pandemic, is susceptible to sharp fluctuations in its stock price due to single drug development, leading to unstable cash flow. While the stock price can skyrocket rapidly, it can also plummet just as quickly.

In contrast, pharmaceutical companies—sometimes referred to as "Big Pharma," like Johnson & Johnson (JNJ) and Pfizer (PFE)—tend to have more stable cash flows and less stock price volatility. These firms have stable cash flows and less volatile stock prices due to diversified drug portfolios. Their primary source of profit is patented drugs, alongside substantial yearly R&D investments. Additionally, these companies frequently expand into other areas, such as medical devices and broader healthcare services.

What are the factors that affect biotech stocks?

Biotech stocks hold an allure for investors, promising the potential to rapidly turn fledgling companies into overnight successes worth millions. The fortunes of these companies largely hinge on two pivotal factors: the outcomes of clinical trials for their new drugs and the all-important approval from the U.S. Food and Drug Administration (FDA).

Typically, small and mid-sized biotech firms concentrate their resources on developing a handful of products. These early development stages are cash-intensive. Positive clinical trial results or an FDA nod can send stock prices soaring, while negative outcomes or regulatory rejections can lead to a precipitous decline in value.

Investing in biotech stocks can therefore be a high-stakes game, offering the chance for exceptional returns as well as the risk of significant losses.

However, the factors that could impact the industry's overall trend are more complex from an industry perspective. Wall Street firms believe investor interest in biotech may be increasing due to three main drivers: lower interest rate expectations, increased mergers and acquisitions, and technological innovation.

It's crucial to recognize that these drivers affect not just individual companies but the biotech industry as a whole. Ultimately, a company's or sector's sustained growth is contingent upon its ability to generate and increase profits over time.

Three biotech indexes

Investors can track the overall trend of biotech companies through industry indexes. However, as the industry develops, there are more and more indexes tracking biotech companies.

According to a report by the NYSE, as of March 2023, the assets of funds tracking biotech indexes globally had reached $54 billion.

Among these indexes tracked by funds, the top three most popular by assets are the Nasdaq Biotechnology Index, the S&P Biotechnology Select Sector Index, and the ICE Biotechnology Index.

S&P Biotechnology Select Industry Index (SPSIBI)

The S&P Biotechnology Select Industry Index (SPSIBI) was launched in January 2006, tracking biotechnology companies under the GICS industry classification standard. These companies include biotechnology stocks listed on all major US exchanges.

The index is compiled using the Modified equal-weighted method. In other words, each constituent stock in the index has the same weight regardless of market value. The benefit of this is that small and medium-cap stocks also have a significant impact on the index.

As of December 29, 2023, there are 120 constituent stocks in the index, with the weight of the top ten constituent stocks reaching 16.3%.

According to ETF Database data, the largest asset size of the ETF tracking the SPSIBI index is XBI (SPDR S&P Biotechnology ETF).

• Weighting method: Modified Equal Weighted

• Constituent stocks: 120

• Weight top ten constituents: 16.3%

• Related ETF: XBI

*The index data is from The S&P Biotechnology Select Industry Index Factsheet as of December 29, 2023, and the Related ETFs are sourced from top assets-tracking ETFs on ETF Database.

Nasdaq Biotechnology Index（NBI）

The Nasdaq Biotechnology Index (NBI) was launched in 1993. It tracks biotechnology companies listed on the Nasdaq under the ICB industry classification. It is worth noting that the index includes not only biotechnology companies but also a small number of pharmaceutical companies.

The index is compiled using a modified capitalization-weighted method, which means that companies with larger market capitalization have a greater impact on the index. However, NBI is rebalanced every quarter with constituent stocks capped at 8% (top 5) and 4% (rest). This can avoid the influence of large companies on the index.

As of December 29, 2023, there are 225 constituent stocks in the index, with Vertex Pharmaceuticals (VRTX) being the largest weighted constituent stock with a weight of 8.5%, and the top ten constituent stocks accounting for 50.41%.

According to ETF Database data, among the ETFs that track the NBI Index, the largest ETF by asset size is BIB (ProShares Ultra Nasdaq Biotechnology). It is important to note that BIB is a leveraged ETF, and its ups and downs are about twice as large as the intraday index changes, accompanied by higher risks.

• Weighting method: modified capitalization-weighted

• Constituent stocks: 225

• Weight top ten constituents: 50.41%

• Related ETF: BIB

*The index data is from the NASDAQ Biotechnology Factsheet as of December 29, 2023, and the Related ETFs are sourced from top assets-tracking ETFs on ETF Database.

ICE Biotechnology Index (ICEBIO)

ICE biotechnology companies under the ICE industry classification standard. These companies include biotechnology stocks listed on all major US exchanges.

The ICE Biotechnology Index (ICEBIO) tracks biotechnology companies under the ICE industry classification standard. These companies include biotechnology stocks listed on all major US exchanges

It is worth noting that on November 3, 2023, the ICE Biotechnology Index was renamed the NYSE Biotechnology Index (NYSE Biotechnology Index).

The index is compiled using the modified float-adjusted capitalization-weighted method, which makes two adjustments on the basis of market capitalization weighting: one is to use liquid market value instead of total market value; the other is to adjust the weighting every quarter.

As no information about its constituent stocks is provided in the Factsheet of the index, we can learn more about the ETFs tracking the index.

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

As of December 31, 2023, IBB has a total of 227 constituent stocks, among which Vertex (VERX) is the most weighted constituent stock, with the weight of the top ten constituent stocks reaching 50.38%.

• Weighting method: modified float-adjusted capitalization-weighted

• Constituent stocks: 227

• Weight top ten constituents: 50.38%

• Related ETF: IBB

*The index data is from the ICE Biotechnology Index and IBB Factsheet as of December 31, 2023, and the Related ETFs are sourced from top asset-tracking ETFs on ETF Database.

The pros and cons of the three major biotechnology indexes

Some investors may wonder how to choose among the numerous biotech indexes available.

To make an informed decision, we should consider three critical factors:

Weighting methods: Both the NBI and ICEBIO are market capitalization-weighted indexes, which means that larger companies with higher market caps sway the index's performance more heavily. On the flip side, the S&P Biotechnology Select Industry Index (SPSIBI) adopts an equal-weighting approach. This allows smaller and mid-sized companies to influence the index just as much as their larger counterparts, providing a better reflection of trends in smaller biotech companies.

Composition of the indexes: While NBI and ICEBIO are similar in their market-cap-weighted approach, they differ in the stocks they include due to distinct industry classification standards. Additionally, ICEBIO and SPSIBI  are exclusively focused on biotech firms, whereas NBI integrates a few pharmaceutical giants into the mix. Furthermore, NBI limits its scope to NASDAQ-listed companies, whereas ICEBIO and SPSIBI cover a wider range by including companies from all major U.S. exchanges.

Historical performance: According to NYSE reports, SPSIBI has shown greater volatility compared to the other two indexes between 2013-2022, with its annual returns either leading the pack or trailing at the end. Specifically, between 2013 and 2022, SPSIBI finished first in annual returns for six years and last for four. In contrast, ICEBIO has shown superior long-term returns, boasting total gains of 5.18%, 6.33%, and 12.61% over three, five, and ten-year spans, respectively, outshining its counterparts.

*Past performance does not indicate future performance. The market is risky, and investment should be approached with caution.

To summarize:

• The biotech sector is a niche within healthcare known for its high investment demands, considerable risks, and the potential for significant returns. Unlike traditional pharmaceutical companies, biotech stocks share a closer resemblance to those in the technology sector.

• Factors influencing biotech stocks include clinical trial results, FDA approval, interest rates, mergers and acquisitions, and technological innovation.

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

• An analysis of historical performance reveals that the SPSIBI is more volatile, whereas ICEBIO has delivered superior long-term returns when compared with both NBI and SPSIBI.