Why active managers thrive in the biotechnology sector
There are many reasons to believe that the next decade may offer opportunities for active managers across the board to outperform, but this is particularly the case in certain industries, where active investors appear to have an enduring edge over passive strategies.
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The debate about the merits of active and passive investing attracts a lot of attention in the investment world and many commentators have a clear, almost evangelical, preference for one or the other.
The reality is that different markets require a differentiated approach. For example, it would be difficult to beat the S&P 500 in an environment where seven “magnificent” stocks drive the bulk of the return, as was the case in the US in 2023. It would be hard for any active manager to match that market’s return without exposure to those dominant stocks. In such conditions, passive may have the upper hand.
Some parts of the market, however, tend to favour an active strategy. Biotechnology is one because the benefits that stem from the specialist knowledge of experienced managers can make a meaningful difference to long-term outcomes. Below we explore the reasons why that is the case.
Selectivity can improve outcomes
Passive investing, whether it is through an index-tracker or Exchange-Trade Fund (ETF), means indiscriminate exposure to everything within the index or basket that is being replicated. That means exposure to the high quality stocks, the low quality stocks and everything in between. It also means exposure to a huge disparity in value, and that is particularly the case in the biotech sector.
Investing in an actively managed biotech strategy like International Biotechnology Trust (IBT), however, provides investors with access to experienced fund managers that are fully committed to the biotech sector and have extensive industry expertise. Active managers have many tools at their disposal which can help to protect a portfolio from the volatility that an indiscriminate passive approach would experience.
Firstly, active managers are well placed to understand and identify the underlying potential in companies, as the science behind a company’s development pipeline is fundamental to its ultimate probability of success. For example, when constructing IBT’s portfolio, we conduct an extensive review of each company’s valuation and management capabilities, while also weighing fundamental scientific analysis, including the interpretation of clinical trial data and the relevant regulatory framework. Specifically, IBT looks for realistically priced, well-managed and well-financed businesses addressing areas of unmet medical need. Publicly listed biotech firms that have a product close to, or already through, the drug approval stage are highly attractive, as these naturally incur less risk and a shorter timeframe to profitability.
At the same time, actively managed trusts also have the opportunity to avoid the most over-valued and lowest quality companies (sometimes the two go hand in hand). At IBT, we avoid companies which are developing “me too” drugs which lack differentiation from products already on the market. We also avoid companies that may struggle to access the necessary finance to fund lengthy clinical trials, companies with unrealistic valuations, companies operating in controversial areas such as opioids, and companies where the probability of success is deemed unattractively low. This means the portfolio can be actively tilted towards the companies that show meaningfully better chances of fulfilling their economic and scientific potential. Currently IBT’s portfolio holds 68 stocks whereas its benchmark index, the Nasdaq Biotechnology Index (NBI) covers 225 securities.
Capturing alpha from M&A
Within the biotech ecosystem we often see large pharmaceutical companies acquiring biotech companies with promising products, rather than undertaking early-stage R&D in house. This is an important source of alpha generation in the sector. While IBT’s managers do not hold assets purely because they consider them to be likely acquisition targets, the qualities that attract IBT’s managers to a company are also attractive to a pharmaceutical acquiror. At the time of Amgen’s bid for Horizon in December 2022 at a 40% premium to the share price, IBT held 13.5% of its NAV in Horizon. Similarly, when Pfizer bid for Seagen in March 2023 at a 32.7% premium to the prevailing share price, IBT held 10.2% of its NAV in Seagen. A passive investor would have held only the index weighting which would have been 2.1% in the case of Horizon and 3% in Seagen.
Adapting to the macroeconomic environment
Much of the capital that flows in and out of the smaller cap biotech companies is driven by sentiment towards the macroeconomic environment, rather than by industry or company fundamentals. For example, the recent performance of the smaller biotech companies has been closely linked to US interest rates. When money flows into passive strategies, it involves indiscriminate buying of all stocks in the index, regardless of valuation or quality. This can result in some of those index constituents becoming overvalued, particularly smaller companies whose shares may lack liquidity (of which there are plenty in the world of biotech). Conversely, when money flows out of passive strategies, the opposite can occur, with good quality companies being sold off indiscriminately and unnecessarily. This contributes to the biotech sector’s pronounced investment cyclicality that we explored last month.
Active managers, such as those at IBT, navigate this investment environment by changing the shape of the portfolio, which can dramatically reduce the volatility of the cycle. If the manager considers the sector to be overheated (such as during the height of the pandemic) the portfolio can be positioned towards more liquid, stable, established biotech companies which continue to offer value and growth, mitigating downside in the event of a major correction. Conversely, at times when the market looks to be finding its way out of a downturn and valuations are more attractive, which IBT’s managers consider to be the case currently, an active manager can ramp up a portfolio’s exposure to the more exciting, smaller, development-stage names in the sector and IBT’s managers made this adjustment in the last quarter of 2023. An active investor running a closed end fund can also borrow additional money, known as gearing, which could enhance positive returns, although it should be noted that gearing may enhance losses in a falling market. A passive investor must either ride the cycle, exposing them to substantial volatility, or reduce exposure to the entire sector, thereby potentially missing out on a source of stable returns, visible earnings, growing demand and burgeoning innovation.
Better diversification
Many investors buy a passive strategy because they think it gives them better diversification. In fact, the opposite can be true. For ETFs and index trackers that are simply replicating an index, anomalies such as the performance of Moderna during 2021, can lead to a worryingly high degree of exposure to a single stock.
The NBI index is rebalanced quarterly and new constituents are admitted annually. In 2021, when Moderna’s Covid vaccine was grabbing the world’s attention, its valuation was pushed to unsustainable levels with its market cap peaking at USD180bn in September 2021. Few industry experts felt that this valuation was justifiable. While there was obvious value in Moderna’s Covid vaccine, there was uncertainty about its longevity and its remaining products were unproven and somewhat speculative. However, even though the NBI caps stocks to a maximum 8% position each quarter, in between rebalancing events, Moderna became a much larger index position reaching 14% of the index. In turn, its value was pushed even higher by passive investment flows. A sharp correction was ultimately inevitable and active managers were able to avoid exposure to the 70% fall in Moderna that followed over the next six months.
Diversification can be achieved in a more intentional and strategic way in an actively managed portfolio. IBT’s managers are careful to diversify the portfolio across development stages, by therapeutic area and by size. As such, an active strategy with a disciplined, long-term, fundamental approach provides investors with the flexibility to ensure their biotech exposure is well balanced and that no single stock – or type of stock – becomes too dominant. This should also ensure a less volatile journey than that of the index.
Managing volatility
Biotech companies are inevitably exposed to a series of binary events as they navigate the clinical trials involved in bringing a new product to the market. A passive investor has no way of reducing exposure to these events, which can inevitably lead to volatility. Active managers, however, may seek to further reduce volatility through what is known as binary event trading.
Markets are inherently optimistic, so much of the potential upside in a binary event situation can become priced into a stock in advance of an announcement. If they ensure they only invest in stocks with sufficient liquidity to enable nimble trading, an active manager can capture this anticipatory rise and then reduce the portfolio’s exposure ahead of the event. If the event is ultimately negative, they then avoid the catastrophic market correction that follows. If the event is positive, however, they can rebuild the position quickly at a significantly lower risk-weighted valuation, albeit perhaps at a slightly higher price.
Public and private
Actively managed funds like IBT have the opportunity to invest in both public and private assets, which provides a broader opportunity set. This can be particularly beneficial in innovative industries such as biotechnology, where many businesses may not even consider a stock market listing until they are relatively well-progressed in the process of proving the value of their technology.
A modest exposure to unquoted businesses can help to differentiate a portfolio from the passive index. Furthermore, while investments in private companies generally carry a longer lead time to profitability due to their early-stage nature, the growth potential can be far greater. IBT has 5-15% of its portfolio in private assets via funds managed by venture specialists SV Health Investors and SV’s portfolio managers have cultivated a strong track record of adding value by looking beyond the stock exchange for interesting long-term opportunities.
Fees
The fees payable on a passive ETF are usually lower than those payable for an actively managed fund, but it stands to reason that investors would pay something for the additional expertise and active management skills of a fund manager. IBT’s management fees of 0.90% are only 0.55% more than the iShares Biotechnology ETF (IBB) fees of 0.35%. Additional performance fees become payable if the fund significantly outperforms the index but, in such a situation, by definition shareholders still beat the index. As long as an investor believes that an active manager can outperform the index by more than the difference between the management fees of an active and passive fund, then relative fees are unlikely to be a key motivation for an investor to opt for a passive approach.
Conclusion
Passive strategies may be an appropriate option for investors looking for broad exposure to an overall market or theme to consider, but they undoubtedly have their flaws. There are many reasons to believe that the next decade may offer opportunities for active managers across the board to outperform, but this is particularly the case in certain industries, where active investors appear to have an enduring edge over passive strategies. Biotechnology is one such sector, and we believe IBT represents an attractive option for investors looking for exposure to a carefully curated portfolio of high potential businesses in an exciting industry with a bright future.
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International Biotechnology Trust plc Risk Considerations
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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