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Recent Volatility Providing Potential Buying Opportunity In The Biotechnology Space

Summary IBB was pulled back roughly 20% from its 52-week high this week with shares plunging from $400 to $320 per share during the recent market weakness. Persistently low oil prices, fear of an imminent rate hike and weakness in China have indiscriminately pulled down all indices over the past week. These external events are largely extraneous to the biotechnology sector and thus may present a buying opportunity throughout pullbacks if adding to a position or initiating a new position. Medical and prescription drug expenditures are projected to grow at an average rate of 5.8% and 6.3% annually through 2024, respectively. Taken together, this may present a potential buying opportunity especially given the recent market volatility. Introduction: The confluence of persistently lower oil prices, fear of an imminent rate hike and more notably weakness in China have indiscriminately plummeted all indices over the past week. These external events are largely extraneous to the biotechnology cohort yet this group has been taken along for the downhill ride with the broader indices. The biotechnology sector has been on an unprecedented performance streak in both annual and cumulative performance over the past 10 years and accentuated during the latest 5 year timeframe however lately this streak has been tested during the recent market volatility. The biotechnology sector can be highly volatile, however I posit that this cohort has not only established itself as a secular growth sector but these latest events are unrelated to the biotech sector and thus this recent pullback may provide a potential opportunity to add to a current position or initiate a position over time as this correction unfolds. Using The iShares Nasdaq Biotechnology ETF (NASDAQ: IBB ) as a proxy, based on annual and cumulative performance throughout both bear and bull markets, IBB may provide the opportunity investors have been waiting for in the face of the current market downturn. IBB is touched down to register a 20% decline from its 52-week high, shares have plunged from $400 to $320 at one point per share during the recent market weakness, presenting a potential buying opportunity. Growth expenditures as a rational for buying on major pullbacks: Per the Centers for Medical and Medicaid Services, medical expenditures are projected (from 2014 through 2024) to grow at an average rate of 5.8% per year. This translates into 1.1% faster than GDP throughout this time period thus the healthcare expenditures as a percentage of GDP are expected to rise from 17.4% in 2013 to 19.6% by 2024. Despite several years of growth below 5%, health spending is projected to have grown 5.5% in 2014. Faster health spending due mainly to ACA health insurance coverage and rapid growth in prescription drug spending. The domestically insured is projected to have increased from 86% in 2013 to 89% in 2014 as 8.4 million individuals are projected to have gained coverage. Post 2014, national health spending is projected to grow at a 5.3% clip in 2015 and peak at 6.3% in 2020. Given these projections, this scenario bodes well for the biotechnology sector as more individuals have access to health coverage and prescription drugs. In terms of prescription drug expenditures, spending is projected to have grown 12.6 percent in 2014 to $305.1 billion. Driving growth were new specialty drugs and increased prescription drug use among people who were newly insured. Prescription drug spending growth is projected to average 6.3% annual growth from 2015 through 2024. Taken together, as the biotechnology sector continues its innovation and continuous supply of medications to treat and cure many different diseases coupled with the growth in overall medical spending may present an investment opportunity especially given the recent market volatility. Secular growth case for buying on major pullbacks: In addition to case outlined above (e.g. highlighting the disconnect between the events bringing down the broader indices and the biotechnology sector on a whole) the biotech sector has displayed its resilience in both bear and bull markets with secular growth. The returns for IBB have been very impressive in both annual and cumulative performance, unparalleled by any major index. Over the past 10 and 5 year time frames, IBB has posted cumulative returns of over 360% and 325%, respectively. These results are unrivaled by any major index, outperforming on a 10 year cumulative basis of 295%, 240% and 300% for the S&P 500, Nasdaq, and Dow Jones respectively (Figure 1). These returns are accentuated during the previous 5 years. IBB notched cumulative returns of 325%, outperforming the S&P 500, Nasdaq and Dow Jones by 245%, 215% and 265%, respectively (Figure 2). IBB has cumulatively outperformed all indices by roughly 3-fold and 2.5-fold over the 10 year and 5 year time frames, respectively (Figures 1 and 2). (click to enlarge) Figure 1 – Google Finance comparison of IBB returns relative to the S&P 500, Nasdaq, Dow Jones over the previous 10 years (click to enlarge) Figure 2 – Google Finance comparison of IBB returns relative to the S&P 500, Nasdaq, Dow Jones over the previous 5 years IBB has displayed impressive resilience in the face of the market crash in 2008, the bear markets of 2011 and the very volatile market thus far in 2015. During the market crash of 2008, IBB posted an annual return of -12.2% while the S&P 500, Nasdaq and Dow Jones posted returns of -37.0%, -40.0% and -31.9%, respectively (Figure 3). During the bear market of 2011, IBB posted an annual return of 11.7% while the S&P 500, Nasdaq and Dow Jones posted returns of 2.1%, -0.8% and 8.4%, respectively (Figure 3). Thus far during the highly volatile market of 2015, IBB posted an annual return of 13% while the S&P 500, Nasdaq and Dow Jones posted returns of -5.8%, -0.8% and -8.6%, respectively (Figure 4). These data suggest that IBB outperforms during bear markets and thus has established itself as a secular growth sector and in the face of unrelated economic events may provide a buying opportunity. (click to enlarge) Figure 3 – Morningstar comparison of IBB annual returns relative to the Nasdaq over the previous 10 years (click to enlarge) Figure 4 – Google Finance comparison of IBB annual performance thus far in 2015 relative to the S&P 500, Nasdaq and Dow Jones Conclusion: As the confluence of these economic events seemingly disconnected in bringing down the biotechnology sector coupled with expenditure growth in overall health and prescription drug spending, it may be a good time to consider capitalizing on this correction via adding to existing positions or initiating a new position in this cohort given this opportunity. Being opportunistic and capitalizing on the recent volatility on pullbacks to slowly add to or initiate a position may be the opportunity investors have been waiting on to pounce on IBB. Data suggests, provided a long-term position that volatility within the biotech sector is negated by its long-term performance that is unparalleled by any major index. This sector provides high returns unrivaled by any major index with moderate risk (based on its resilience during the bear markets of 2008 and 2011 and thus far in 2015) and volatility. IBB may be providing investors with a great opportunity to add or initiate a position for any long portfolio desiring exposure to the biotechnology sector with a long-term time horizon given the recent market conditions. References: CMS.gov Statistics Trends and Reports Disclosure: The author currently holds shares of IBB and is long IBB. The author has no business relationship with any companies mentioned in this article. I am not a professional financial advisor or tax professional. I wrote this article myself and it reflects my own opinions. This article is not intended to be a recommendation to buy or sell any stock or ETF mentioned. I am an individual investor who analyzes investment strategies and disseminates my analyses. I encourage all investors to conduct their own research and due diligence prior to investing. Please feel free to comment and provide feedback, I value all responses. Disclosure: I am/we are long IBB. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

The Difference Between ‘Investors’ And ‘Traders’

I received a lot of complimentary comments on my last post ( Relax, have a glass of wine ) in which I urged investors to take a deep breath and focus on the market fundamentals which indicated that the macro backdrop was tilted bullishly. However, there was a small minority whose comments ran to the tone of the post being ridiculous advice. The latter group undoubtedly were highly short-term focused and belonged to the community of traders. I would like to take this post to distinguish between my two personas, namely my inner trader and inner investor. During the current period of market turmoil, my inner trader has to deal with many challenges, not the least of which are the wild daily and overnight swings in asset prices. By contrast, my inner investor (and underline the term “investor”) takes a much more longer term view. The typical “investor” and can only check the market briefly during the day and only trades occasionally. They certainly do not have the time, resources or inclination to be fret over and trade swings in overnight stock index futures. While the recent stock market downdraft has been surprising, the average diversified investor hasn’t really been hurt very much. That’s because the bond market has acted as a very good diversifier, unlike 2008 when market contagion leaked into the credit markets. To illustrate my point, imagine someone with a portfolio with a passive 60% stocks and 40% bond allocation. He invests the stock portion into SPY and the bond portion into AGG . The simulation assumes that all income is re-invested back into the ETF of the respective asset classes (SPY dividends to SPY and AGG income into AGG). Once a year on December 31, he re-balances the portfolio back to the target 60-40 weight. Here is a chart showing how far his equity weight is off his 60% target since September 2003, when the data series for AGG began. As of Tuesday, August 25, 2015, the worst day of the stock market drawdown so far, the portfolio was underweight its stock benchmark by only 2.2%, which means that the bond market rallied enough to make up most of the losses suffered by equities. Contrast that with past experiences in 2008 when the equity weight cratered, or even the correction of 2011 when bond diversification had a less adequate effect. (click to enlarge) In 2015, diversification worked! Investors who have diversified portfolios shouldn’t really be freaking out. So relax, have a glass of wine *. * Investors who made the decision to be 100% equities either made the conscious investment policy decision to assume equity volatility in return for a higher rate of return, or the current episode taught them a valuable lesson on the importance of an investment policy. Disclaimer: The opinions and any recommendations expressed in this blog are solely those of the author. None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Smart Neutral Portfolios

Summary Asset allocation decisions are the most important ones that investors make. Here are some recommendations. Modern Portfolio Theory asserts that the global market portfolio is optimal for the average investor, but its underlying assumptions are too restrictive. Also, defining the global market portfolio is no easy trick. An article by Doeswijik, Lam, and Swinkels (2012) provides very helpful research. Target date funds from Vanguard, Fidelity, and Schwab provide an indication of conventional thinking regarding asset allocation for U.S. investors. In a blend of these approaches, “smart neutral portfolios” are presented for conservative, moderate, and aggressive investors. The Need for Neutral Portfolios Most investors realize that asset allocation decisions are the most important ones that they will make. Studies have shown that the vast majority (90% or more) of the long-term return of any overall portfolio is determined by its asset mix. The risk and return implications of even relatively modest differences in asset mix can be dramatic, particularly when compounded over time. Investors, especially those savvy enough to realize the dire consequences of being wrong on asset mix, are afraid of making a mistake. They are eager for guidance that will help them make sound asset allocation decisions. This paper, which builds upon an earlier paper concerning asset mix , is designed to fill that need. Neutral portfolios provide a recommended asset mix in the absence of an informational edge relative to other investors. They are recommendations for the neutral or normal asset mix for a typical investor. (I focus on U.S. investors.) The circumstances of each investor will influence the neutral portfolio appropriate for their situation. Typically, level of investor risk aversion and expected investment horizon are the most important circumstances that affect neutral portfolios. Investors with the lowest levels of risk aversion (highest risk acceptance) and/or the longest investment horizons will have the most aggressive portfolios. Those with high risk aversion and/or short horizons will prefer the more conservative portfolios. Below I present three neutral portfolios, for conservative, moderate, and aggressive investors. These can be further customized as needed. The Global Capital Market Portfolio Under a fairly restrictive set of assumptions, Modern Portfolio Theory (MPT) recommends that all investors own a representative slice of the global market portfolio. The global market portfolio includes all capital assets weighted according to their total market value (capitalization). Capital assets clearly include stocks, bonds, and commercial real estate, but could also include commodities, currencies, private equity, and even human capital in the form of education. However, usually the global market portfolio is assumed to include only investable capital assets, such as publicly traded stocks, bonds, and real estate securities. Many investors find great comfort in the fact that, so defined, MPT provides a universal, exact, and intellectually defensible neutral portfolio. It is the portfolio that can be owned by all global investors. It is assumed to be the most efficient portfolio, meaning that it has the highest expected return compared to expected risk. Although limiting the global market portfolio to publicly traded stocks, bonds, and real estate securities is common, arguably it leaves out a large segment of assets that could be very important, including non-traded real estate and privately owned companies. Measuring the size of these less common components of the global capital market, and calculating their returns, is problematic. The returns of publicly traded real estate (e.g., REITs) and publicly traded companies that invest in private equity can be used to proxy for non-traded real estate and private company returns, but the approximation will be rough at best. The best recent work attempting to measure the market values of a very wide variety of global capital assets is found in a 2012 paper by Doeswijik, Lam, and Swinkels (DLS) entitled Strategic Asset Allocation: The Global Multi-Asset Market Portfolio 1959-2011 . In the table below, I cite their figures as a starting point and then make several adjustments. I mentioned above that MPT has some fairly restrictive assumptions. These are not necessarily realistic. For example: MPT Assumption: Well informed investors will not prefer capital assets in their home country over other global assets. Reality: Investors are generally saving to fund future expenditures in their home country denominated in their home currency, so a bias in favor of the home market is entirely sensible. MPT Assumption: Global capital markets are frictionless, with no tax, legal, structural, informational, or cultural barriers to the free flow of capital. Reality: Important barriers exist in many countries, and these often reinforce the home market bias. MPT Assumption: All investors are motivated only by economics (risk and return). Reality: Some important investors are motivated mainly by politics, including governments and central banks. Many institutional investors operate with various regulatory or tax structures that affect their investments. All investors are influenced to some extent by various psychological biases. MPT Assumption: All capital assets are priced efficiently and reflect all knowable return and risk expectations. Reality: The volatility in the pricing of capital assets far exceeds any rational changes in return and risk expectations, indicating a high level of time-series inefficiency. (Price changes are far too large relative to changes in fundamentals.) Furthermore, objective studies have shown certain “anomalies,” or excess risk-adjusted returns, associated with characteristics such as value and momentum. The DLS global portfolio data is an excellent start, but in my opinion, several adjustments are needed as described below. (click to enlarge) The first adjustment I make to the DLS data (from the original article) is to break out U.S. stocks, bonds, and real estate from non-U.S. stocks, bonds, and real estate. This facilitates tilting towards U.S. assets for U.S. investors. In column 1 above I estimate the breakout based upon recent data, which indicates that U.S. stocks and real estate are about 50% and U.S. bonds about 65% of the global totals. The second adjustment has to do with the DLS estimate of the value of global real estate. Their figure of $3.7 trillion (column 1) is untenably low compared to the figures provided by multiple other sources. Recent citations for the value of global commercial real estate (which excludes owner-occupied residential real estate) range from $13.6 trillion ( DTZ quoted in the Financial Times , 2015 ) to $26.6 trillion ( Prudential Real Estate, 2012 ) to $31.2 trillion ( Bank for International Settlements, 2011 ). In column 3 I use the lower end of the range, which increases the estimated value of global real estate from 4.4% of the global market portfolio to 14.6%. The third adjustment I make is to zero out the value of all government bonds in column 5. My rationale is that the size of the government bond market is artificially inflated by the fact that both issuers (governments) and some buyers (central banks) are motivated more by politics than by economics. Also, unlike corporate bonds, government bonds largely fund current consumption rather than true capital investment. Perhaps going to zero is an over-correction, but certainly some major adjustment is warranted. Using the DLS value for total government bonds in the original article (not shown above), I subtracted 65% from U.S. bonds and 35% from developed market bonds, leaving emerging market bonds and inflation-linked bonds unchanged. Column 6 in the table above will be the starting point for forming a set of smart neutral portfolios (that reflect “smart” adjustments to global market value weights). However, further adjustments need to be made to reflect 1) an appropriate level of home country bias for U.S. investors and 2) appropriate levels of portfolio risk for various levels of risk aversion on the part of investors. Unlike the MPT-based market capitalization weighted global market portfolio, there is no universally-recognized economic theory to guide the calibration of either home market bias or portfolio risk levels. However, target date funds from the three largest providers of such funds, Vanguard, Fidelity, and Schwab, provide logical reference points. Target Date Funds Most investors find it most comfortable to hold an asset mix that is similar to what they believe other investors hold. Behavioral finance has shown that many investors seek “the comfort of the herd.” Their instincts tell them that staying in the center of the herd is the safest option. Particularly for those who are looking after the assets of others and therefore do not share in the economics of their allocation decisions, minimizing “maverick risk” (the risk of being different and wrong) is usually the chosen path because that is the best way to appear prudent and burnish one’s investment career prospects. As Keynes observed, “worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” Individual investors often seek asset allocation guidance from authority figures that are perceived as experts, often in the form of asset allocation funds offered by recognized investment management companies. That is, they seek a “default option” when it comes to asset allocation. This is one reason for the enormous popularity of target date funds, lifestyle funds, and multi-asset funds in 401(k) plans. These funds are designed to guide the investor towards an appropriate default choice based upon easy, objective criteria such as expected retirement date and/or risk tolerance. For the most part, these funds focus on liquid publicly traded asset classes and are no doubt heavily influenced by what will make investors comfortable. Consequently, they reflect conventional wisdom and consensus thinking with respect to asset allocation. (click to enlarge) The table above presents three types of target date funds for three different investment horizons. “Income” funds would be for those who are currently in retirement, and who presumably therefore prefer a conservative portfolio. “Target 2020” funds would be for those expected to retire in 2020, with a moderate amount of portfolio risk. “Target 2040” funds are for younger workers who are assumed to have more aggressive risk preferences. While there are differences among the three fund providers, there is a high degree of consensus. As the target date lengthens, stock allocations increase and bond allocations decrease markedly. This is not at all surprising. Perhaps more surprising is the strong consensus regarding home market bias. In all cases, U.S. stocks are preferred to international stocks by more than 2 to 1. The home market bias is even stronger for U.S. bonds, which are preferred over international bonds by more than 4 to 1. Fidelity is somewhat of an outlier with extremely low international bond allocations, preferring an allocation to commodities instead. The fund companies are also differentiated with respect to their attitude towards short-term funds. Smart Neutral Portfolios The purpose of this paper is to put forth a set of neutral portfolios for the long-term (although they will require rebalancing and updating from time to time). They are “smart” neutral portfolios only in the sense that they go beyond the simple capitalization-weighted global market portfolio by making a few adjustments that I believe are sensible, as described above. A final set of smart neutral portfolios, conservative/short horizon – column (3), moderate/medium horizon – column (5), and aggressive/long horizon – column (7) are shown in the table below. (click to enlarge) In selecting the weights for the three smart neutral portfolios, I attempted to balance between the adjusted DLS global portfolio weights shown in column (1) and the averages for the corresponding target date funds. In general, I believe that the smart neutral portfolios are similar in spirit to the corresponding target date funds, but are somewhat better diversified, and as such, should provide a slightly more attractive return/risk tradeoff over the long-term. Clearly, the allocation percentages assigned to each asset class are round numbers. There is no decimal point accuracy implied. Investors should deviate from these weights according to their own preferences and circumstances. Over time, actual portfolio weights will drift away from their initial weights because of divergent performance among the asset classes. Investors may want to rebalance back toward initial weights based upon a time schedule and/or the degree of deviation between initial and actual weights. It may be advisable to review the weights at each year-end, particularly in taxable accounts, which may give rise to the opportunity to harvest losses for tax purposes. (That is, selling a fund to realize a loss and reinvesting in another similar fund.) The table below illustrates how the smart neutral portfolios could be implemented using Vanguard ETFs for the core stock, bond, and real estate allocations. Vanguard tends to have the lowest expense ratios of any ETF provider, as well as among the lowest bid-ask spreads, making theirs the among the least expensive ETFs to both own and to trade. (I have no relationship with Vanguard and receive no compensation from them. I am merely a fan. Substitute funds can be found from other fund companies. Similarly, I have no relationship with and do not receive compensation from the providers of the non-core funds I have selected below.) (click to enlarge) Individual investors with both IRAs and taxable portfolios will want to put the highest turnover and highest yielding ETFs into their IRAs in order to reduce taxes. Some investors may prefer to use “smart beta” funds for the core stock, bond, and real estate allocations listed above. The term smart beta is used to describe passively managed funds that are constructed using algorithms other than market capitalization weighting. Often these smart beta funds are tilted towards one or more fundamental factors, such as yield, volatility, momentum, or various measures of value such as earnings, book value, assets, or cash flow. Critics of smart beta point out that any weighting methodology other than market capitalization amounts to an active bet relative to market cap, and that the higher turnover and higher fund expense ratios of smart beta funds may negate any benefit for investors. I am a proponent of carefully selected smart beta funds, particularly those associated with various forms of momentum and value. However, I try to tilt towards particular factors and away from market cap weighting only when I believe that the reward/risk ratio is particularly favorable. I use a rather complicated process to make these decisions, and I charge my clients a fee. For purposes of this paper, however, I have opted to stick with capitalization-weighted core funds more appropriate for the do-it-yourself investor. Disclosure: I am/we are long VNQ, USCI, JNK, QAI, PSP. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: My long and short positions change frequently, so I make no assurances about my future positions, long or short. The information contained in this article has been prepared with reasonable care using sources that are assumed to be reliable, but I make no representation or warranty regarding accuracy. This article is provided for informational purposes only and is not intended to constitute legal, tax, securities, or investment advice. You should discuss your individual legal, tax, and investment situation with professional advisors.