Pharmaceutical ETFs - ETF Sector Report

The Pharmaceutical Industry

The pharmaceutical industry is facing challenges like sluggish prescription trends, EU pricing pressure, intensifying generic competition, pipeline failures and limited late-stage catalysts.

With revenue growth stalling or slowing down, companies have been resorting to cost-cutting and share buybacks to drive bottom-line growth.

Moreover, merger and acquisition (M&A) activities have increased and we expect this trend to continue. We also expect a significant pickup in in-licensing activities and collaborations for the development of pipeline candidates. Instead of developing a product from scratch, which involves a lot of funds, pharmaceutical companies are shopping for mid-to-late stage pipeline candidates that look promising.

Small biotech companies are also game for in-licensing activities and collaborations. Most of these companies find it challenging to raise cash, thereby making it difficult for them to survive and continue with the development of promising pipeline candidates. Therefore, it makes sense for them to seek deals with pharmaceutical companies that are sitting on huge piles of cash.

Another recent trend seen in the pharmaceutical sector is a focus on emerging markets. Until recently, most of the commercialization efforts were focused on the US market -- the largest pharmaceutical market -- along with Europe and Japan. However, emerging markets are slowly and steadily gaining more importance and several companies are now shifting their focus to these areas. Emerging markets should see strong sales thanks to higher demand for medicines. Several factors like government initiatives for healthcare, new patient population, and increasing use of generics should help drive demand. Growth in emerging markets could help stabilize the base business during the industry's 2010-15 patent cliff.

Industry Performance

The pharmaceutical industry, in general, has been lagging the S&P500 over the past few years. Factors like patent expiries, generic competition, US healthcare reform and pipeline disappointments have hampered the performance of the industry. Global spending for medicines is expected to reach almost $1.1 trillion by 2015, according to the IMS Institute. However, the five year compound annual growth rate of 3-6% represents a significant slowdown from the 6.2% annual growth seen in the last five years.

6-Month Outlook

We currently have a Neutral outlook on large-cap pharmaceutical stocks (Zacks #3 Rank). While pharmaceutical companies will continue to face challenges like pricing pressure and genericization, growth in emerging markets, cost-cutting efforts and contribution from new products could help reduce the impact.

3-Year Outlook

Our outlook on the pharmaceutical industry for the next three years remains Neutral. Patent expirations will continue hampering the performance of the sector as several major drugs like Lipitor, Zyprexa and Plavix go off-patent. Moreover, the government is exploring options which will help increase the availability of generics. Recently, the Obama administration announced that it is looking to implement a proposal under which the exclusivity period for biologics will be cut down by 5 years thereby allowing generics to enter the market sooner. The government is looking to bring this proposal into effect from 2012. The government is also seeking to increase the availability of generics by preventing companies from entering into anti-competitive or “pay for delay” agreements which push out the availability of generics. These initiatives, if implemented, would result in additional pricing competition and genericization in the pharmaceutical industry.

According to the IMS Institute, market share for branded drugs will continue declining in the next five years. Branded drugs market share, which declined from 70% in 2005 to 64% in 2010, is expected to decline to 53% by 2015. The decline will be driven by patent expiries, with generics accounting for a significant part of pharmaceutical spending especially in the US.

However, the negative impact of genericization should be set off by contributions from emerging markets which are gaining more importance. According to data provided by IMS, spending by pharmerging markets is expected to increase from 12% in 2005 to 28% by 2015. Moreover, products approved in the 2009-2011 timeframe should be major contributors to revenues in the next three years.

10-Year Outlook

In the next 10 years, the pharma industry should show some signs of recovery. By that time, the industry should be out of the major patent cliff period and new products should be contributing significantly to results. Increased pipeline visibility and appropriate utilization of cash should increase confidence in the sector.

Pharmaceutical Industry Exchange Traded Funds (ETF)

Exchange traded funds in the pharmaceutical industry include:

Pharmaceutical HOLDRs (PPH);
SPDR S&P Pharmaceuticals ETF Holdings (XPH);
Dynamic Pharmaceuticals Holdings (PJP) and
iShares Dow Jones US Pharmaceuticals Index Fund (IHE).

PPH was launched by Merrill Lynch HOLDRs in January 2000. The top 10 holdings (representing 94.94% of total assets) of this fund consists primarily of large-cap pharma companies with a couple of specialty pharma companies thrown into the mix. PPH is not linked to any specific benchmark. The total assets as of September 27, 2011 were $508.44 million representing 14 holdings. The fund charges a flat fee.

XPH launched by State Street Global Advisors in June 2006, tracks the S&P Pharmaceuticals Select Industry Index. The top 10 holdings (representing 45.62% of total assets) of this fund include biotech companies, large-cap pharma companies as well as generic and specialty pharma companies. The total assets as of September 27, 2011 were $224.81 million representing 31 holdings. The fund’s expense ratio is 0.35%.

PJP launched in June 2005 by Invesco PowerShares, tracks the Dynamic Pharmaceuticals Intellidex Index. The fund usually invests at least 90% of its total assets in common stocks that comprise the Index, which is designed to provide capital appreciation by thoroughly evaluating companies based on a variety of investment merit criteria, including fundamental growth, stock valuation, investment timeliness and risk factors. The top 10 holdings (representing 46.64% of total assets) of this fund consist mostly of large-cap pharma companies with a couple of biotech companies thrown in. The total assets of the fund as of September 27, 2011 were $166.42 million representing 30 holdings. The fund’s expense ratio is 0.60%.

IHE, launched in May 2006 by iShares, seeks investment results that correspond generally to the price and yield performance, before fees and expenses, of the Dow Jones US Select Pharmaceuticals Index. The top 10 holdings (representing 58.72% of total assets) of this fund consist mostly of large-cap pharma companies with a few generic companies thrown in. The total assets of the fund as of September 27, 2011 were $194.12 million representing 40 holdings. The fund’s expense ratio is 0.47%.

The top 10 holdings of all four funds, as in September 2011, are provided below:

Investment Thesis

Of the four ETFs discussed above, we would recommend XPH. Although PJP has delivered the highest return in the past one year, PJP’s expense ratio as well as tracking error are the highest.

On the other hand, XPH’s expense ratio is the lowest (we are unable to compare with PPH as the fund charges a flat fee) and the fund also has the lowest tracking error (9.75%). Moreover, XPH represents a balanced mix of stocks with the fund representing biotech companies, large-cap pharma companies as well as generic and specialty pharma companies. Unlike its peers, the fund’s investment is not focused entirely on large-cap pharma companies which are facing issues like generic competition, weak pipelines, and patent expirations. Mid-cap, biotech and generic company holdings could ensure higher returns especially in the long-term.

Keeping these factors in mind, we recommend XPH.

ETF	PPH	XPH	PJP	IHE
Issuer	Merrill Lynch HOLDRS	State Street	Invesco PowerShares	iShares
Asset Value	$508.44 million	$224.81 million	$166.42 million	$194.12 million
Holdings	14	31	30	40
Expense Ratio	Flat fee	0.35%	0.60%	0.47%
Tracking Error (1 year)*	9.82%	9.75%	10.23%	9.93%
Index 1-Yr Return	N/A	22.80%	48.84%	36.80%
ETF 1-Yr Return	N/A	22.58%	47.85%	36.10%