An ETF That Aims to Capitalize on Upcoming Drug Breakthroughs

In the biotechnology and pharmaceuticals industries, pride of place can be a crucial factor in a company's success. Companies race to develop products and new drugs in the hopes that they will advance through multiple phases of testing by the U.S. Food and Drug Administration (FDA). Although it's rare for a new drug to officially receive approval, when this happens, it is a tremendous boon for the developing company. In turn, investors in that company tend to see big profits as well.

Since 2014, the ALPS Medical Breakthroughs ETF (SBIO) has worked to target companies in the biotech and pharmaceuticals industries that have products in an advanced phase of FDA clinical trials. In doing so, the exchange-traded fund (ETF) attempts to capture some of the dramatic gains that newly approved medicines can bring their developing companies. Below, we'll explore how SBIO selects these companies and why it might be worth an investor's consideration.

Company Stipulations

SBIO considers companies only if they meet several stipulations. First, a potential target must have a product in the second or third phase of trial by the FDA. These drugs have already passed the first round of clinical trials and have met certain standards of safety for use in selected patients. Drugs in these stages are being tested for efficacy, side effects and the monitoring of adverse reactions among patients.

SBIO also only looks at small- and mid-cap companies with market capitalizations of no less than $200 million and no more than $5 billion. According to a report by Bloomberg, SBIO is focused only on companies that have the financial resources to remain in business for a 24-month period into the future.

The ETF reconstitutes its underlying index twice per year, in June and December. Stocks are reviewed and rebalanced once per quarter and according to a modified market capitalization weighting system. Any individual stock can be weighted at no more than 4.5% within SBIO's index, according to ALPS. As of this writing, SBIO has more than $247 million in net assets and an expense ratio of 0.50%. This makes SBIO cheaper than its rival, the Virtus LifeSci Biotech Clinical Trials ETF (BBC), which has an expense ratio of 0.85%.

Considerations

According to the FDA website, approximately 70% of drugs selected for phase one trials move on to phase two. However, only 33% of phase two drugs move on to phase three, and only 25-30% of phase three drugs move on to phase four, the final stage of clinical trials. This means that many of the companies with drugs in phase two or three trials will not ultimately see those drugs meet final approval. For this reason, SBIO's approach is somewhat risky.

Nonetheless, SBIO offers investors a means of approaching the new drug game with less risk than they would take on investing in individual companies on their own. Beyond that, SBIO has generated returns of almost 50% since its inception in 2014, which is in line with the performance of the S&P Biotech Index.

With the Trump administration likely to continue to remove some of the barriers in the FDA approval process over the coming years, it's likely that more and more of SBIO's picks will be successful in bringing new drugs to market. This may make an ETF like SBIO (or its competitor BBC) an enticing opportunity for investors looking to capture some of the potential upside in the FDA clinical trials process. Of course, SBIO remains more volatile than traditional biotech ETFs or those focused on diversified healthcare companies. On the other hand, SBIO also offers the potential for greater returns in the end.