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Reducing risk in a risky sector
Investing directly in biotech stocks can be considered quite a risky endeavour. Simply picking a company that has a good idea with a mechanism to treat a severe disease and holding it for the long term is fraught with all sorts of risks. Once drugs have been shown to be effective in laboratory testing, trials on humans begin. This is a highly regulated, three phase process and there is a long list of things that potentially can go wrong. Firstly, the drug could turn out to be toxic or poorly tolerated. If reactions are severe, this may result in a “clinical hold” being placed on the trial which, once announced to the market, will cause the stock price to plummet.
Secondly, the drug could be proven to be less effective than other treatments currently on the market. This will result in future commercial failure: even if approved for use, that drug is unlikely to become the treatment that doctors choose to prescribe. Thirdly, the regulator could issue a “complete response letter”, or “CRL”, which is a decision not to approve a drug in its present form. This may be because the regulator deems further trials necessary, or further data submissions, or a change in manufacturing procedures. While a CRL will inevitably cause a drop in share price, depending on the reason for the CRL, that may be followed by a recovery, once the reason for the CRL and the market has properly understood the likelihood that the company can remedy the situation.
These factors contribute to the need for expertise and experience to effectively navigate the biotech investment environment. However, for those in the know, there are ways to reduce exposure to such risk.
1. Expertise
Understanding the science is key. Being able to evaluate a company for investment is only possible if you have a good understanding of the science behind the product itself (how likely it is to be effective), the landscape for that disease area (evaluating whether this product will be more effective than the existing treatment approaches), the regulatory backdrop, trial design (some types of trials are less likely to gain regulatory approval than others) and of course the effectiveness of the management team who will be key in driving a successful drug development process.
2. Basket of stocks
Holding a basket of many stocks reduces exposure to individual companies, any of which could experience a “blow up” at any time. The Nasdaq Biotech Index currently includes more than 250 companies, so there is plenty of choice. Having big “elephants” in a biotech portfolio is a very risky proposition: at International Biotechnology Trust (IBT), individual companies rarely account for more than 8% of the portfolio.
3. Diversification across different groupings
The biotech sector can be subdivided by therapeutic area (eg. oncology, inflammatory diseases etc), by size and by development stage (eg. early-stage, revenue growth, profitable). Balancing a portfolio across each of these subsectors helps to spread the risk. When there is a significant event in a particular company within a therapeutic area, the knock-on effect can be felt by other companies that have similar drugs, so spreading the risk is key. Similarly, companies in the early stages of their clinical trials tend to be the riskiest, so having a broad spread across development stages makes sense.
4. Dipping toes into new stocks
Getting to know a management team and a company gradually and following them along their journey through the clinical trial minefield is something that makes sense. At IBT, new positions in early-stage companies tend to be a fraction of the whole portfolio [typically below 1%]. These positions can then be grown as the portfolio managers get to know the company and its management better and build up confidence in the company’s prospects.
5. Trading around events
The clinical trial process is highly regulated and therefore (except for an unanticipated clinical hold for toxicity) is fairly predictable in terms of timing. If a portfolio manager follows a company closely, it is possible for them to know more or less when to expect clinical data readouts or news from the regulator on approvals. Reducing exposure to a company as it approaches this type of binary read-out means that if the news is bad, the portfolio is protected from the sharp downturn that follows. Conversely, if the news is good, it is possible to buy back into the, now de-risked, company at a lower risk-weighted valuation. A proportion of the good news is often priced into the stock in advance which means that a timely sale ahead of the announcement leaves less upside on the table. For example, recently, IBT had a favoured stock in the portfolio called Uniqure, a rare disease gene therapy company. Uniqure focussed primarily on an approved treatment for Haemophilia B but had a secondary programme undertaking trials for Huntington’s Disease therapy. IBT’s portfolio managers followed their own process and reduced exposure to Uniqure ahead of an anticipated read-out on the Huntington’s Disease trial. The news was interpreted as negative by the markets and the stock fell by around 40%. IBT’s risk mitigation measures meant that the portfolio’s exposure to the stock was reduced from being a top ten position in the portfolio to a minimal position ahead of the data, of around 0.1%.
6. The unpredictable curveballs
Risk mitigation approaches, as outlined above, can help preserve capital in a biotechnology fund should the binary events have a negative outcome. However, sometimes these ‘blow-up’ situations can be unpredictable in their nature and timing. It is very difficult to avoid such curveballs. As a portfolio manager, it is possible to approximately gauge when a clinical trial is set to readout its data, and to trade into the event accordingly. However, as mentioned above, a severe safety issue mid-trial may trigger a premature stop on the trial, which is called a ‘clinical hold’. Secondly, if a drug is launched onto the market and unexpected safety events occur which was missed during the formal clinical trial process, however uncommon, is still a possibility and will significantly hit the company’s share price. Examples of post approval safety issues include Biogen’s Tysabri, which remained on the market and Merck’s Vioxx, which was withdrawn completely. It is very difficult to avoid such events.
7. Liquidity
There is little more frustrating for a portfolio manager than being stuck holding an unwanted stock due to lack of liquidity in the market. Very large funds with a small number of positions will find it very difficult to unwind their positions in a hurry. A mid-sized fund with a broad number of investments will enable managers to be nimble in the portfolio’s access to smaller companies, allowing a more active management.
8. Closed end structure
In a closed end fund such as an investment trust, investors who wish to exit the fund sell their shares in the fund to another investor rather than redeem them for cash. The biotech sector waxes and wanes due to fluctuating popularity with generalist investors, so having a fixed pool of capital reduces the risk of being either a forced seller of stock at knock-down prices in a market downturn, or being forced to deploy excess inflows, during a period of sentiment-driven hype, which can inhibit getting the best price for a stock and risks limiting stock selection opportunities.
9. Gearing
One of the beauties of the structure of closed end funds is that they can borrow extra money to invest. This delivers a performance kicker in the event of a rising market, but in a downturn can exaggerate the losses. Some funds choose a level of gearing and stick with it through thick and thin, however actively gearing a portfolio so that gearing can be added to at times of high conviction, but reduced going into a downturn, helps protect a portfolio from gearing-driven losses.
Biotech’s reputation for being a risky investment sector is not unfounded: clinical trials have unpredictable outcomes, and it is true that the majority of companies which set out on the road of clinical trials in a laboratory do not make it to successful therapy rollout. However, active management - focussing on the aspects that can be controlled and constructing a portfolio that mitigates risk where possible - can reduce exposure to the sector’s volatility.
1Monthly readout of 5 years annualised volatility of International Biotechnology Trust compared to volatility of Nasdaq Biotech Index sourced from Morningstar and Kepler and included in IBT’s monthly factsheet.
Fund risks - International Biotechnology Trust
Capital risk / distribution policy: As the Company intends to pay dividends regardless of its performance, a dividend may represent a return of part of the amount you invested.
Concentration risk: The Company's investments may be concentrated in a limited number of geographical regions, industry sectors, markets and/or individual positions. This may result in large changes in the value of the Company, both up or down.
Currency risk: The Company may lose value as a result of movements in foreign exchange rates, otherwise known as currency rates.
Gearing risk: The Company may borrow money to make further investments, this is known as gearing. Gearing will increase returns if the value of the investments purchased increase by more than the cost of borrowing, or reduce returns if they fail to do so. In falling markets, the whole of the value in that such investments could be lost, which would result in losses to the Company.
IBOR risk: The transition of the financial markets away from the use of interbank offered rates (IBORs) to alternative reference interest rates may impact the valuation of certain holdings and disrupt liquidity in certain instruments. This may impact the investment performance of the Company.
Liquidity risk: The price of shares in the Company is determined by market supply and demand, and this may be different to the net asset value of the Company. In difficult market conditions, investors may not be able to find a buyer for their shares or may not get back the amount that they originally invested. Certain investments of the Company, in particular the unquoted investments, may be less liquid and more difficult to value. In difficult market conditions, the Company may not be able to sell an investment for full value or at all and this could affect performance of the Company.
Market risk: The value of investments can go up and down and an investor may not get back the amount initially invested.
Operational risk: Operational processes, including those related to the safekeeping of assets, may fail. This may result in losses to the Company.
Performance risk: Investment objectives express an intended result but there is no guarantee that such a result will be achieved. Depending on market conditions and the macro economic environment, investment objectives may become more difficult to achieve.
Share price risk: The price of shares in the Company is determined by market supply and demand, and this may be different to the net asset value of the Company. This means the price may be volatile, meaning the price may go up and down to a greater extent in response to changes in demand.
Smaller companies risk: Smaller companies generally carry greater liquidity risk than larger companies, meaning they are harder to buy and sell, and they may also fluctuate in value to a greater extent.
Valuation risk: The valuation of some investments held by the Company may be performed on a less frequent basis than the valuation of the Company itself. In addition, it may be difficult to find appropriate pricing references for these investments. This difficulty may have an impact on the valuation of the Company and could lead to more volatility in the share price of the Company, meaning the price may go up and down to a greater extent.
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