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The Dangers of ETF Investing

By Rob Fannon, editor Phase 1 Investor
Friday, December 8, 2006

It’s often called the knowledge hurdle.
The monthly research trips. The years of intensive study required. The industry contacts you’ve got to have in the Rolodex. The ability to value new drugs...
The knowledge hurdle is what makes biotech investing an incredibly difficult – and usually costly – activity. Unless you’re able to climb over it, you’re bound to lose money in biotechnology. It also makes this type of investing incredibly profitable if you have the time and budget to get it right.
As I told Phase 1 readers last month, our average biotech stock is up 70% this year... and Big Pharma’s takeover binge has helped send valuations in this sector to historical highs. Merck’s buyout – at a 100% premium – of one of our portfolio stocks, Sirna Therapeutics (RNAI), is the latest sign that now is a great time to be a biotech investor.
So how did one of the major biotech ETFs manage to lose money this year?
Most people think that ETFs conveniently eliminate the hardest part of investing. There’s no longer a need to delve into thousands of individual stocks in search of the big winner. Simply buy ETFs from the hottest sectors and leave it alone. That’s not the case with the Merrill Lynch Biotech ETF (BBH). The Merrill Lynch ETF is actually down 7% on the year.
Why? Just two companies lock up a full 63% of the ETF, hardly representative of the supposed “basket of companies” that ETFs claim to represent.
Amgen (AMGN) and Genentech (DNA) make up 25% and 38% of the Merrill Lynch ETF, respectively. These two companies attract the dumb money when the sector gets hot.
The problem is, Amgen and Genentech no longer represent the typical innovative player in the biotech sector. With market caps over $80 billion, each is more like a Big Pharma behemoth than a biotech company. And, just like most big drug companies, they’re overvalued and overfollowed.
If you insist on owning an ETF in this field, you’d do better to find equally weighted ETFs, such as the PowerShares Biotech and Genome ETF (PBE).
But the best way to invest in the sector is to follow the Phase 1 strategy and buy individual companies with the highest risk/reward ratios. This is the same cherry-picking strategy that Big Pharma employs when snatching up smaller companies to fill thinning pipelines. The big drug companies have been on an acquisition tear recently, which will continue. Here’s one reason why:
This past weekend, the drug industry lost one of the most promising drugs in development due to safety problems. Pfizer (PFE) was forced to abandon the new heart drug it was developing to replace Lipitor, the top-selling drug in the world, as it comes off patent in a few years.
Pfizer has to swallow the fact that the $800 million it invested in the drug will go for naught, not to mention the $21 billion of lost market cap.
Quite simply, Big Pharma’s loss works to biotech’s gain. Major biotech indices climbed on news of Pfizer’s setback. Expect sector valuations to continue to improve across 2007 and beyond.
The big drug companies will keep on the massive buyout hunt, which took off in the second half of this year. As I mentioned, this rush to fill up pipelines has helped us make an average of 70% this year. I believe it’s just the beginning of a multiyear trend.
Just don’t count on making the most of it with an ETF.
Good investing,
Rob Fannon
Editor, Phase 1 Investor

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Market Watch
Symbol Price
S&P 500 1221.53 +1.3% +10.1%
Oil 37.77 +1.5% -2.8%
Gold 135.20 -0.1% +13.4%
Silver 27.93 +0.4% +47.9%
US-Dollar 80.67 -0.8% +8.1%
Euro 1.32 +0.6% -12.1%
Volatility 19.39 -9.2% -8.2%
Gold Stocks 564.53 +1.3% +10.6%
10-Year Yield 3.00 +1.4% -9.6%

World ETFs
Symbol Price
USA 122.56 +1.3% +10.2%
Canada 30.44 +1.3% +13.8%
Russia 21.63 +2.3% +16.7%
India 37.73 +1.9% +20.0%
Israel 16.47 +0.9% +9.7%
Japan 10.58 +1.0% +7.4%
Singapore 13.88 +1.0% +19.2%
Taiwan 14.72 +1.6% +17.8%
S. Korea 56.56 +1.7% +22.8%
S. Africa 70.85 +3.9% +22.9%
China 45.06 +1.4% +0.1%
Lat.America 52.82 +1.4% +6.7%

Sector ETFs
Symbol Price
Oil Service 136.18 +1.5% +14.8%
Big Pharma 64.13 +0.6% -3.3%
Internet 72.13 +0.7% +22.3%
Semis 16.03 +2.1% +28.9%
Utilities 31.21 +0.3% +1.6%
Defense 18.51 +1.3% +10.1%
Nanotech 9.99 +1.3% +0.0%
Alt. Energy 9.95 +1.4% -4.4%
Water 18.31 +1.1% +12.2%
Insurance 16.07 +1.2% +18.3%
Biotech 20.58 +1.1% +27.1%
Retail 19.65 +0.1% +28.4%
Software 24.59 +0.9% +24.1%
Big Tech 53.73 +1.0% +21.9%
Construction 12.99 +2.1% +13.3%
Media 13.57 +1.1% +25.0%
Consumer Svcs 67.26 +0.8% +23.3%
Financials 54.87 +2.4% +5.2%
Health Care 64.22 +0.7% +1.3%
Industrials 63.25 +1.6% +19.7%
Basic Mat 73.57 +1.6% +21.6%
Real Estate 55.24 +1.4% +23.8%
Transportation 91.17 +1.4% +25.6%
Telecom 22.48 +1.1% +17.1%