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Exclusive Interview With Paul Yook, BioShares’ Portfolio Manager

Summary I interview Paul Yook, the portfolio manager of BioShares. We spoke about the BioShares Biotechnology Clinical Trials ETF (BBC). This ETF offers investors pure exposure to the biotech market without exposure to special pharmaceutical companies. After my article on iShares Nasdaq Biotechnology ETF (NASDAQ: IBB ) portfolio strategy, many readers have asked about other biotech ETFs that could act as replacements for IBB. Though my first reaction is to say ALPS Medical Breakthroughs ETF (NYSEARCA: SBIO ) because I was previously long on SBIO, I realized I don’t know much of the differences among the different biotech stocks. SBIO is often brought up when BioShares Biotechnology Clinical Trials ETF (NASDAQ: BBC ) is mentioned, but much of the information on BBC – and the differences between it and SBIO – seem to be elusive, at least online. So, I scheduled an interview with Paul Yook, the portfolio manager of BBC to ask him more about this little-known biotech ETF. The interview follows. Q : Because most drugs fail their clinical trials, many of the holdings in BioShares Biotechnology Clinical Trials ETF will likely fall, requiring the handful of winners to compensate for the losses. What is the likelihood of such compensation? PY : Great question. Let’s keep in mind that most publicly trading biotech companies have a number of shots on goals. Though the majority of products fail, most companies have follow-on products. So, companies have multiple compounds focusing on the same downstream target. And they’ll have multiple programs – different disease targets and drug candidates. So it doesn’t necessarily require the lead product or one individual product to make a successful drug. There are a number of successful publicly traded companies such as Regeneron (NASDAQ: REGN ) who had a number of failures in their early years but ended up being successful investments over time. So, when you ask the odds of successful investments in biotech, we believe that diversification through a variety of investments is important. It is really difficult to pick a single winning stock and stomaching the volatility that goes with investing in biotech. Having a diverse basket is really important in investing in clinical stage companies. Q : So basically, all of the holdings you have in BBC have multiple shots at success? PY : They do because – again every company is different – most publicly trading companies have a diverse pipeline. In addition, these management teams really are portfolio managers in a way. They are assessing the risk of these programs over time. And they can pivot: They can move into another program; they can acquire a program; they can change their scientific approach. You’re really investing in a management team, just as you are in an individual drug or portfolio of drugs. Q : If I’m not mistaken, BBC removes a company from their holdings if that company doesn’t currently have a drug in a clinical trial, correct? PY : Exactly right. BBC invests in companies with lead companies in phases I, II, and III. Q : What is your stance on the increasing failure rate of clinical trials? PY : As far as clinical trials over time, there is variability from year to year. Some of the scientific approaches we’ve seen have sped up the time it takes to get a drug approved, starting from inception or conception of the idea. There are other disease categories such as heart failure or stroke that have had very poor statistical results. We look at failure rate across category. We believe investing across these categories is the most prudent way to invest. Q : So you’re looking at the failure for each type of drug instead of simply clinical trials in general? PY : Exactly. Certain categories tend to be of lower risk. For example, if a company is developing an enzyme replacement therapy for a genetic disease, it will tend to have a very high success rate because the biology of such a therapy is well known. Q : In general, what are the criteria you use to pick your holdings? PY : Our criteria for our index funds are rules-based. They are really very simple. We first screen for biotech companies that are primarily focused on human therapeutic drugs. There are other companies that focus on other industries, such as specialty pharmaceuticals, diagnostics, or life science tools. We exclude these from our biotech funds because we believe biotech ETFs should give investors biotech-only exposure. We also screen companies that have a minimize size and liquidity: 250 million in market cap and $200 million of average traded volume. This way we exclude smaller companies that have problems with financing and capital. Of course, our main criterion is that the company being in the clinical trial stage. We split the universe up into the companies in that early stage, which go into BBC, from the later stage companies that go into the BBP fund. Q : Seeing as BBC is not actively managed, how much weight should investors give to the biotech specialists behind this ETF? PY : I have been involved in active management, and what I find in the investment universe today is that biotech investors have become very knowledgeable. What you have today is many scientists at large institutions such as hedge funds and mutual funds. You also have highly sophisticated retail individuals active on blogs and Twitter. I think the playing field has become much more equalized, and the market has become much more efficient for biotech investing. I think the differential between active and management has really narrowed. In many ways, I think there’s an edge to investing in passive strategies. What we’ve seen is what I call “alpha destruction” from active studies. There was a Bloomberg study in the summer that looked at a variety of healthcare and biotech hedge funds and mutual funds, finding them to underperform the passive ETF strategies. Of course, active strategies also have negative tax ramifications, lockup minimums, and liquidity issues. This has been widely written about. There are large advantages in passive, ETF strategies. I believe that passive strategies really help investors avoid some of the pitfalls of those active strategies. A lot of investors tend to sell out of fear, whereas passive strategies by rule avoid that pitfall. Q : Right. I think a lot of investors are looking for ETFs because of the lower management fees involved. BBC charges 0.85%. In addition, many investors don’t have the science background to make good choices in the biotech market, which is why it’s important for an ETF to employ specialists in index creation. So for BBC, what is the general background of your fund’s biotech specialists? PY : Keep in mind that we do have a passive strategy. I did lay out our rules, which are fairly simple. But it is important that we manage our own index. We employ 25 specialists, both biotech and industry specialists. We look for people with a passion in investing in biotech and currently have 6 Ph.D. level scientists. We have a wide variety of investment and capital market experience, from investment banks and equity research to hedge funds and mutual funds. The reason it’s important to have specialists creating our biotech indexes is because we employ a level of understanding in the creation of these indexes. Most indexes today date back to the 1990s. At that time, the biotech industry was in its infancy. It was unclear the direction the industry was heading. It was also unclear what the eventual profit model would be. Back then, we saw sub-industries like genomics and stem cell technologies that people didn’t really understand. Today, the industry is very different. There are many sub-segments of the biotech industry. We apply a lot more understanding of the nuances of the industry and have designed truly investable, broad indexes. Q : I am currently long on ALPS Medical Breakthroughs ETF. Convince me to switch to BBC. PY : I think anyone who’s invested in any other biotech fund has probably had a very good experience because the biotech industry has made a lot of technological advances and financial results over the five years. I wouldn’t want to convince anyone to move out of a biotech stock, mutual fund, or competing ETF. But I think it’s important to understand the differences between the investments. Our funds are unique, and it’s important to understand that. Our funds are equally weighted, which means that no company will be an outsized exposure. Biotech is very interesting because you will usually have outsized weighting to an individual drug, regardless of company size. Gilead (NASDAQ: GILD ) showed that to investors about a year ago, last December, when there were pricing concerns that surfaced for its largest drug – Sovaldi and Harvoni for hepatitis C. Within two trading days, Gilead traded down 19%. To have a $150 billion market cap company show that volatility really does show that market cap weighting tends to increase volatility. So, as you can imagine, there are a number of market-weighted biotech ETFs, and they showed higher-than-normal volatility during that period. I think splitting up the risk into the higher-volatility BBC fund and the lower-volatility BBP fund is important because we view them as totally different asset classes: high-risk biotech and low-risk biotech. Some people will want a mix of them; others will want to focus their exposure to these asset classes separately. And because you asked, a third important feature of our fund is that we give people pure biotech exposure. By design, we have excluded special pharmaceuticals, which have been knocked on lately. I think specialty pharma can be good, but some have had political scrutiny these days. It’s important to differentiate these two types of companies because specialty pharma tends to invest 5 to 10% of sales in R&D, whereas biotech companies – even very large ones such as Biogen (NASDAQ: BIIB ) – will invest more than 20% of their sales into R&D. Therefore, specialty pharma companies do not exist in the BBC fund. I think probably every other ETF fund does contain these companies. A lot of other biotech companies have become diluted in what BBC holds because of the emergence of the mega biotech company, such as Biogen or Gilead, as well as the specialty pharma model, such as Horizon, whom we would not classify as a biotech company. Q : Final question: What would you say to an investor who believes the biotech industry is currently a bubble? PY : Well, I think that we have had a 30% or more correction over the past few months and that the long-term growth prospects remain very strong. There are strong arguments that pricing needs to be addressed. I believe these concerns are valid. But some of the scientific approaches are nothing short of remarkable. And valuations have come in significantly. I’m seeing some individual stocks that are making investing in the biotech industry as a whole through ETFs very interesting. Summary Overall, the emphasis Paul Yook expressed in this interview was one of “purity.” While other biotech ETFs diverge out from the biotech industry, investing in big pharma, the BioShares ETFs focus exclusively on biotech. In fact, while BBC currently pales in comparison to most other biotech ETFs in terms of popularity, BioShares holds a second ETF – clearly for the purpose of keeping BBC purely clinical trial based. Hence, the emphasis of “purity” seen for BBC makes this ETF a good investment for an investor who wants biotech and only biotech. That is, if you want explicit exposure to the price gains seen by the creators of up-and-coming drugs, this is your best bet. If you’re looking for something more broad, such as exposure to companies no longer creating drugs but currently in the marketing and sales phase in addition to those up-and-comers, another ETF would be more suitable. Of course, you can gain exposure to both by putting some capital in BBC and some more in BBP or a healthcare ETF. In either case, BBC has a place in the portfolio of investors who believe in the future of biotech breakthroughs.

Asset Class Weekly: Emerging Market Debt

Summary In an effort to help investors discover the broad opportunity set beyond the stock market, I am introducing a new weekly report called The Asset Class Weekly. My priority each week is to explore in depth an asset class that might not be on the radar screen for the average investor. The inaugural Asset Class Weekly will focus on emerging market bonds. When people think of investing, their minds typically turn to the stock market. This perspective is certainly understandable, as the financial media concentrates nearly all of its time discussing the many stocks of companies that people like to own. And when accessing their employee retirement programs, the menu of fund offerings is typically made up stock mutual funds of all styles, sizes and geographies along with token bond and money market offerings thrown in to round out the line up. But capital markets have so much more to offer to investors than just stocks. And these various other asset classes can provide investors with attractive returns opportunities as well as the ability to better control risk through more meaningful portfolio diversification. Introducing The Asset Class Weekly In an effort to help investors discover the broad opportunity set beyond the stock market, I am introducing a new weekly report called The Asset Class Weekly. My priority each week is to explore in depth an asset class that might not be on the radar screen for the average investor. The inaugural Asset Class Weekly will focus on emerging market bonds. More specifically, the analysis will concentrate on the U.S. dollar denominated sovereign debt from emerging markets. Emerging Market Bonds So what exactly are emerging market sovereign bonds? It is debt that is issued by the government of developing economies around the world. The list of countries that make up a measurable part of the emerging market bond universe is vast ranging from Mexico, Brazil and Venezuela in the Americas to Ukraine, Latvia and Hungary in Eastern Europe and China, Indonesia and Malaysia in the Far East. Why the focus on U.S. dollar denominated debt? This is because a large number of bond issuance across the emerging world are done in local currencies. Thus, U.S. dollar denominated debt offerings from emerging market governments helps neutralize for U.S. investors the currency risk that would otherwise come with investing in this category. For example, those with exposures to bonds denominated in local market currencies stand to benefit if the U.S. dollar (NYSEARCA: UUP ) is weakening relative to these local currencies, but will struggle if the U.S. dollar is strengthening versus these same currencies. And in the current market environment where the U.S. Federal Reserve remains determined to raise interest rates while much the rest of the world is intent on easing, the U.S. dollar has been strengthening markedly relative to many of these local emerging market currencies. Hence the focus on the U.S. dollar denominated offerings at least for now instead. Gaining Investment Exposure Three exchange traded funds make up nearly all of the assets in the U.S. dollar denominated emerging market sovereign bond market ETF space. They are the following: iShares JP Morgan USD Emerging Market Bond ETF (NYSEARCA: EMB ) $4.7 billion in total assets 0.68% expense ratio PowerShares Emerging Markets Sovereign Debt Portfolio (NYSEARCA: PCY ) $2.7 billion in total assets 0.50% expense ratio Vanguard Emerging Market Government Bond ETF (NASDAQ: VWOB ) $514 million in total assets 0.34% expense ratio Why Emerging Market Bonds? Emerging market bonds provide measurable risk-adjusted return advantages and portfolio diversification benefits that makes the category worth monitoring for consideration in a diversified asset allocation strategy. First, U.S. dollar denominated emerging market sovereign bonds have a fairly low returns correlation relative to other key asset classes. Over the past eight years, the correlation of its weekly returns relative to the U.S. stock market as measured by the S&P 500 Index (NYSEARCA: SPY ) is a reasonably low +0.52. And when compared to the core U.S. bond market as measured by the iShares Core U.S. Aggregate Bond (NYSEARCA: AGG ), it has an even lower returns correlation of just +0.32. Moreover, it also offers a differentiated returns experience from its emerging market equity (NYSEARCA: EEM ) counterpart with a correlation of just +0.43. In short, emerging market bonds offer a unique returns experience that is measurably differentiated from the primary investment categories as well as emerging market stocks. Second, the category offers a “middle of the road” alternative from a return, risk and income perspective. For example, the S&P 500 Index has a 3-year historical standard deviation of returns, which is a way of thinking about risk in terms of the volatility of returns, at 12.21% along with a yield of 2.0%. The core U.S. bond market, on the other hand, has a far lower standard deviation of returns at 2.95% but also offers a yield to maturity of 2.4% that is not much higher at present than the dividend yield on the stock market. As for emerging market stocks, they are even further out the risk spectrum than U.S. stocks with a standard deviation of 16.65% along with a yield of 2.2%. But emerging market bonds offer investors a middle ground between these options with a standard deviation of 7.17% that is higher than core U.S. bonds but lower than U.S. stocks and a yield to maturity that is meaningfully higher toward 5.7%. Third, U.S. dollar denominated emerging market bonds have held up fairly well in the recent market environment. Since the start of 2014, the ETFs in the category have fallen in the middle of the returns range relative to U.S. stocks and core U.S. bonds. (click to enlarge) The category has also meaningfully outperformed its emerging market equity counterpart. (click to enlarge) And drawing back from a longer term perspective, we see that since the early days of the financial crisis eight years ago at the start of 2008 through today, emerging market debt has delivered a comparable total returns experience to the U.S. stock market with less price volatility along the way. This strikes a stark contrast to emerging market stocks that tracked the S&P 500 Index through the early post crisis years only to have fallen flat over the last four years since the summer of 2011. (click to enlarge) Thus, based on its overall characteristics, there is much to like about the category at any given point in time both from an individual returns and portfolio construction perspective. What Accounts For The Returns Difference Between EMB and PCY? When considering an allocation to U.S. dollar denominated emerging market sovereign bonds, it is important to note that meaningful differences exist between the construction of the iShares JP Morgan USD Emerging Market Bond ETF and the PowerShares Emerging Markets Sovereign Debt Portfolio. First, the EMB much like the smaller VWOB has a far larger number of individual bond holdings relative to the PCY. For while the EMB has 846 holdings, the PCY only has 89. Second, the EMB and PCY will have different effective durations at any given point in time. At present, the EMB has a duration of 7.05 years versus the PCY at 8.21 years. Both of these duration readings are longer than that of the core U.S. bond market as measured by the AGG currently at 5.30 years. Lastly, the country mixes that make up the EMB and PCY portfolios are very different from one another. And unlike EMB, the PCY is designed to maintain equal weights across its emerging market sovereign debt allocations. As a result, the exact nature of the risks driving either portfolio can be entirely different at any given point in time. The following are the top 10 country weights that make up the EMB portfolio as of November 19. Mexico 6.20% Russia 5.61% Turkey 5.41% Indonesia 5.16% Philippines 5.11% Brazil 4.51% China 4.03% Hungary 4.02% Colombia 3.85% Poland 3.71% In contrast, the following are the top 10 country weights that make up the PCY portfolio as of November 20. Ukraine 6.48% Russia 4.26% Venezuela 3.82% Pakistan 3.66% Qatar 3.63% Latvia 3.62% Romania 3.57% Croatia 3.57% Lithuania 3.55% Poland 3.53% In short, these are two very different products from an individual emerging market country exposure perspective. This is a risk element that is important to evaluate closely before making an allocation to either product. Are Emerging Market Bonds Worth An Allocation Today? Despite all of the merits associated with an allocation to emerging market bonds in a diversified asset allocation strategy, I am not recommending an allocation to U.S. dollar denominated emerging market bonds at this time. This does not mean that I am not actively monitoring to potentially make an allocation to the space at some later date in time. But I am inclined to stand away from the category at the present time for the following reasons. To begin, while the option adjusted spread over comparably dated U.S. Treasuries has widened notably from its lows from the summer of 2014, at 349 basis points this yield spread remains somewhat low to average at best from a long-term historical perspective. Perhaps more importantly, this yield spread may not be fully reflecting some of the mounting short-term to intermediate-term risks facing the category at the present time. Many emerging market sovereigns are in the throes of an economic slowdown to varying degrees. A number of these countries are major commodities exporters, and they have suffered mightily from chronically declining prices for materials such as copper and oil amid supply gluts and declining global demand from the likes of China. And with the U.S. dollar strengthening and the Federal Reserve now considered likely to raise interest rates in December, the economic headwinds may become worse before they get better for many of these countries. The recent decision by S&P to demote emerging market giant Brazil to junk status following the recent credit rating downgrade highlights the current challenges facing some of these emerging market nations at the present time. Lastly, despite their solid recent performance, emerging market bonds are not without the risk of a major price decline at any given point in time. For example, back in 1998 during the outbreak of the Asian Crisis, emerging market bonds plunged by -42%. It should be noted, however, that the financial health of many emerging market nations is vastly better today than it was in the late 1990s. In 2008, emerging market bonds dropped by -34%. And the periodic decline of -10% or more like those seen in 2013 and 2014 should not be ruled out at any given point in time. Recommendation U.S. dollar denominated emerging market bonds have a solid long-term track record of risk-adjusted returns performance and are well suited for inclusion in a diversified portfolio allocation. But at the present time, investors may be well served given generally high valuations coupled with currently weakening economic conditions across the emerging market bond space to exercise patience by waiting to make a long-term commitment to the category. History suggests the potential for periods of downside price volatility that would provide a more attractive entry points. Thus, investors are encouraged to actively monitor the asset class for any sustained period of price weakness to reevaluate the possibility of adding U.S. dollar denominated emerging market bonds to a diversified long-term investment portfolio at that time if fundamental conditions are warranted. Disclosure : This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.

TransCanada – It’s Not The End Of The World, Rather A Buying Opportunity

The president has finally rejected TransCanada’s Keystone XL pipeline. The decision seems more political than economical, but it is bad for TransCanada which has already spent $2.4 billion on the project. Although the market has been focusing on the future of Keystone XL, TransCanada has other projects in its pipeline that could fuel its growth in the coming years. Energy East could be the biggest growth driver in the long term, but the management has laid emphasis on a number of small projects. Earlier this month, the Obama administration finally rejected TransCanada Corp. (NYSE: TRP )’s Keystone XL pipeline on the grounds that the project was not in U.S. national interest and could reflect poorly on the country’s global leadership in protecting the environment. The decision, which was widely anticipated, finally concludes TransCanada’s seven-year efforts in getting an approval for the 830,000 barrels a day pipeline from the current administration. The decision seems more political than economical. It is difficult to imagine how a 1,179-mile pipeline spread over six states which would have mostly carried crude from Canada’s oil sands, but also up to 100,000 barrels a day of North Dakota oil, to Gulf Coast refineries would not lead towards meaningful economic benefits for the U.S. and Canada. Besides, the State Department’s environmental review , released in Jan. 2014, had already stated that the construction of the pipeline will not have any substantial negative impact on the climate. On the contrary, the rejection could increase the Canadian oil sands producers’ reliance on rail for delivering the crude to the U.S., which is far more carbon-intensive than the pipeline. Nonetheless, the decision is bad for TransCanada which has already spent C$2.4 billion on the project. A significant chunk of the expenditure could be written off as non-cash pretax charges in the coming quarters. The investment which related to the physical pipeline and equipment, however, can be utilized on other projects. As I have discussed previously , TransCanada has several options on its table following the rejection. The company can seek remedies under the energy chapter of the North American Free Trade Agreement, construct a rail loop that would connect U.S. and Canadian pipelines, or simply wait until a new U.S. president arrives in 2017 and then file another application. However, it is also important to note that the rejection is not the end of the world for TransCanada. Although the company’s stock declined 5.2% on the day of the rejection and has failed to completely recover completely since, I believe this could be an interesting buying opportunity. Although Mr. Market has been largely focusing on the future of Keystone XL, TransCanada has several other projects in its pipeline that could fuel earnings and cash flow growth in the coming years. This includes the giant Energy East pipeline which is bigger than Keystone XL in terms of investment, capacity and impact on the bottom line. Energy East, which comes with a price tag of more than C$12 billion as opposed to Keystone XL’s C$8 billion, will be able to ship up to 1.1 million barrels of crude per day from Alberta to Eastern Canada. Once Energy East becomes fully operational by 2020, it can lift TransCanada’s annual earnings (EBITDA) by C$1.8 billion. Keystone XL, on the other hand, was supposed to generate annual earnings of C$1 billion. Overall, excluding Energy East and Keystone XL, TransCanada has a backlog of C$15 billion of commercially secured major projects that can lift its annual earnings by more than C$1 billion in the long-term, according to my rough estimate. Energy East pipeline What’s even more interesting is that during the recently held investor day (Nov. 17), TransCanada emphasized that in addition to the major projects, it also has a C$13 billion backlog of eleven smaller projects, none of which require investment of more than C$1.4 billion, which will drive its growth over the next two years. Some of these projects, such as the Houston lateral and terminal, Topolobampo, Mazatlan and Canadian Mainline, will begin to contribute to earnings in 2016 while some of the bigger ones with capital cost of at least C$1 billion each, such as the liquids pipelines Grand Rapids and Northern Courier, will fuel earnings growth beyond 2016. Overall, the small and large projects are forecasted to drive 8% to 14% increase in annual earnings through the end of the decade. This will lead towards an average of 8% to 10% increase in dividends in each year through 2020. That’s higher than the CAGR of around 7% witnessed over the last fifteen years. Thanks to the recent drop following Keystone XL’s rejection, the stock is already offering an attractive yield of around 5%, which is higher than the industry’s average of 3.2%, according to data from Thomson Reuters. I believe the recent weakness could be an opportunity to buy this pipeline stock and earn strong returns in the long-run.