Investing in biotechology with investment trusts

 

Imagine a world where cancer doesn’t kill 10 million people a year. Or where organs can be grown in a lab without the need for donors…by Jo Groves

 
Or a world where genetically-modified crops eradicate widescale famine and reduce poverty. These are just a few of the challenges being addressed by the biotechnology sector, which harnesses the power of living cells for a wide range of applications.

In fairness, biotechnology is not a new concept, with natural biological processes such as fermentation used for centuries in the making of food and drink. However, gene sequencing proved the turning point in 2000, described by then US president Bill Clinton as the “most important, most wondrous map ever produced by humankind”. This breakthrough marked the start of a golden age for the biotech sector.

Some of the most exciting applications for biotech have undoubtedly been in the healthcare sphere, including the development of treatments for previously untreatable conditions. Gene therapy replaces missing or faulty genes with working copies, which has the potential to be a game-changer in treating the underlying cause of genetic disorders such as haemophilia and blindness. Similarly, immunotherapy utilises the power of a patient’s own immune system to fight cancer cells, with ‘checkpoint inhibitors’ transforming the fight against lung, kidney and skin cancers (amongst others).

But the power of biotech goes well beyond the medical, with the sector set to play a key role in tackling some of the world’s most pressing societal and industrial challenges. One such challenge is the transition to clean energy to meet ambitious net-zero targets, with biofuels offering a renewable, low-emission alternative to fossil fuels. Another initiative to reduce our carbon footprint is the development of biodegradable plastics, while the discovery of plastic-eating bacteria in a rubbish dump in Japan has spawned research into a potential solution for the 350 million tons of plastic waste produced each year.

The rate of innovation has been highly impressive to date but artificial intelligence (AI) is likely to prove a powerful catalyst over the next few years. Although AI has a wide range of applications across the whole of the biotech sector, it is expected to transform the development of highly-personalised treatment plans for patients in the medical space, thanks to its speed and accuracy in processing large datasets of complex data.
 

Why invest in biotechnology?

 
Biotechnology is a high growth market which is forecast to increase by 14% each year, from $1.5 trillion in 2023 to $3.9 trillion in 2030, according to Grand View. Healthcare currently accounts for half of this market value, a trend that is expected to continue through this decade.

One of the key drivers of demand is the demographic challenge created by an ageing population. The UN forecasts that the number of over-65s will rise from 800 billion in 2023 to hit 2 trillion by 2067, an increase of 150%.

In addition, increased life expectancy, the prevalence of chronic diseases (such as cancer and diabetes) and the growing middle class in emerging economies will fuel global healthcare spending, which is expected to exceed $1.1 trillion in 2024, according to IQVIA.

Turning to the supply side, the rapid increase in the number of biologic treatments and therapies is constantly expanding the universe of products, particularly for chronic and complex diseases. As a result, IQVIA reports that the biotech sector accounts for 80% of the potential medicines in the global development pipeline. It’s also worth noting that therapies which address some of the less common diseases where no treatment is currently available can sometimes qualify as ‘orphan’ medicines for regulatory purposes. This opens up simplified clinical trials and fast-track approval pathways, in addition to an extended period of market exclusivity, with the UK BioIndustry Association estimating that the typical R&D cost of an orphan drug is around a third less than their ‘non-orphan’ peers.

Another tailwind to returns is the high level of M&A activity inherent in the biotech sector. Due to the expiry of almost 200 key patents by 2030, major pharma companies face a ‘patent cliff’ that includes some of their best-selling blockbuster drugs. This estimated annual revenue shortfall of $200 billion has prompted a record high in M&A transactions as pharma companies look to outsource their R&D to smaller, nimbler biotech companies. This also enables the larger companies to refresh their products lines and leverage the distribution capabilities of their global sales teams, while smaller biotech companies can speed up the time-to-market for new products with ‘patent clocks’ ticking.
 

How difficult is it to invest in biotechnology?

 
Investing in individual biotech companies can be difficult for private investors in terms of research and monitoring. In addition, investing in the biotech sector comes with a high level of complexity due to the specialist nature of the products and technologies. Understanding the science behind drugs and the competitive landscape for each drug is essential, as well as having a detailed knowledge of all the companies operating in the sector. This requires an in-depth knowledge of biology, chemistry, clinical studies, regulatory processes and medical knowledge of the diseases they seek to treat. As a result, specialist fund managers in this field often have years of experience, a related degree and clinical expertise.

Biotech companies also face unique challenges in getting drugs through the research, clinical trial and regulatory approval phases to market, which often takes 10 to 15 years. This requires a high level of capital expenditure, with only 14% of all drugs in clinical trials making it through to regulatory approval, according to the UK BioIndustry Association.

Mitigating this risk of failure can be a major hurdle for investors in individual companies, but investing in a portfolio of companies via a fund increases the overall odds of success, and certainly reduces specific risks through diversification. In addition, professional fund managers can use their in-depth knowledge to further manage risk by reducing exposure to companies ahead of clinical trial results, or avoiding more speculative, unfunded companies.
 

Why invest in biotechnology with investment trusts?

 
Investment trusts are a type of fund that enable investors to gain broad exposure to the biotech sector, while managing some of the risks mentioned above. By buying shares in the investment trust, investors have exposure to the portfolio of assets held by the trust, rather than having to buy shares in individual companies.

There are currently seven trusts specialising in the biotech and healthcare sector on the London Stock Exchange. The scope varies by trust, with some trusts investing in a more concentrated portfolio of companies, while others take a broader approach.

Most of these trusts have managers with extensive knowledge and experience of investing in the biotech sector. By way of example, the managers of the International Biotechnology Trust (IBT), which we look at in more detail below, all have biotech-related degrees, as well as decades of experience in analysing companies in the sector.

The trusts are also differentiated by the nature of their investments, with some focusing more at the riskier, earlier stage of drug development, some specialising in the biotech space and others on the broader healthcare arena, including pharmaceuticals, hospitals and medical technology. In addition, biotech trusts can take stakes in firms that are off-limits to individual investors, because the companies are not publicly listed, or listed in countries that are more difficult for investors to access. Some trusts take stakes in biotech venture capital firms, which allows the managers to piggy-back on the expertise of specialist investors in early-stage, private companies.
 

Biotechnology investment trusts vs open-ended funds

 
It’s fair to say that some of the benefits mentioned above, whether a diversified portfolio or manager expertise, also apply to open-ended funds. However, investment trusts have some unique attributes which may help them deliver superior returns compared to their open-ended peers.

Firstly, open-ended funds are not publicly traded (unlike investment trusts), meaning that the size of the investable fund will rise and shrink with the purchase and sale of units in the fund. This means that open-ended funds typically hold a sizeable proportion of cash in reserve in order to meet redemption requests for investors, which can create a ‘drag’ on returns, and also limits their ability to invest in less liquid stocks.

Investment trusts do not have this problem as publicly traded companies. The buying and selling of shares in the investment trust does not impact the size of the investable fund and, as trusts are not required to keep cash for redemptions, this can boost returns for investors and allow longer-term investment in smaller companies.

Another factor is gearing, whereby the trust can borrow money with the goal of enhancing returns (although it can also increase losses). Trusts are typically able to borrow up to a certain percentage, for example 20% of the assets under management, whereas open-ended funds are not able to deploy gearing.

Lastly, investment trusts can use capital reserves to pay dividends (if required). This can provide income for investors in a sector which is more growth than income-focused, such as biotech.

 

Case study: International Biotechnology Trust

 
Launched: 1994

Manager: Schroder Investment Management

Ongoing charges: 1.3%

Investment policy: The trust aims to deliver long-term capital growth by investing in biotechnology and other life sciences companies.

Comparative Index: NASDAQ Biotechnology Index (NBI)

International Biotechnology Trust (IBT) aims to deliver long-term growth for shareholders by investing in leading biotechnology and other life sciences companies.

Co-lead managers Ailsa Craig and Marek Poszepczynski are bottom-up stock pickers, looking for the best companies in the biotech industry across the market cap spectrum. They also invest in companies at various stages of development, which the managers categorise as profitable, revenue growth or early stage. The managers apply a top-down overlay which allows them to tilt the portfolio into more stable, advanced companies in times of market turbulence, or towards more cutting edge, earlier-stage companies during periods of growth.

IBT also has a small allocation to unlisted funds and companies, which IBT’s board aims to maintain at 5% to 15% of the portfolio. These funds are managed by the team at SV Health Investors, led by Kate Bingham, who headed up the UK government’s Vaccine Taskforce during the pandemic.

In the 10-year period to 20/02/2024, IBT has delivered total share price returns of 180%, putting it well ahead of its AIC peer group average of 130%. In addition, IBT recently featured 12th on the AIC’s list of 28 ISA Millionaire Investment Companies, companies in which an investment of the maximum ISA allowance every year since ISAs were introduced in 1999 would have returned over £1 million. There are no guarantees that this will be repeated in the future, however, the managers believe that improvements in technology and the secular growth trends of a growing middle-class and ageing population should support the biotech sector moving forward.

1) What is the investment trust’s goal?

IBT’s goal is to deliver long-term capital growth for shareholders by investing in biotechnology and life sciences companies

2) What kind of stocks do the managers like?

The managers are predominantly bottom-up stock pickers and look for companies providing treatments for unmet medical needs that offer superior pricing power. They focus on well-financed companies with experienced management teams and boards, innovative high unmet medical products, the potential for high growth and a positive social impact.

The majority of IBT’s portfolio is invested in US biotech stocks, which offer innovative products and access to equity funding, in addition to the regulatory scrutiny of being listed in the US.

3) Are investment decisions driven by a particular investment style?

The managers invest in the best growth opportunities across the full spectrum of the biotechnology sector. They believe that growth in the big names in their benchmark index, the NASDAQ Biotechnology Index, is likely to slow in the years ahead in comparison to smaller peers, mainly as a result of lower innovation and the expiry of patents. In this scenario, the managers’ active approach to asset allocation in the sector should prove beneficial.

However, IBT’s managers look at growth prospects in conjunction with a company’s current valuation and risk profile. They will also look to manage risks around the binary outcomes of drug trials and regulatory approvals, both of which can cause substantial volatility in share prices.

4) How many stocks does the investment trust typically hold?

The trust managers do not have a rigid number of stocks that they hold but they target a portfolio of 60 to 80 companies.

5) What is the investment trust’s dividend policy?

IBT currently aims to pay a dividend equal to 4% of its net asset value at the end of its previous financial year (currently August 31st). This is paid semi-annually, with dividends distributed in January and August.

6) What are the investment trust’s ongoing charges?

The investment trust’s ongoing charges are 1.3%.

7) Does the investment trust have performance fees?

The performance fee on the quoted pool is 10% of relative outperformance above the sterling-adjusted NASDAQ Biotechnology Index plus a 0.5% hurdle. There is a maximum quoted performance fee of 1.25% of IBT’s NAV and it is only payable in respect of financial periods when the NAV per share has increased. The performance fee on the directly held unquoted pool, excluding unquoted funds, is 20% of net realised gains, taking into account any unrealised losses (but not unrealised gains) and is capped at 2% of IBT’s NAV.

There is no performance fee calculated on unquoted funds as the fund manager has carried interest in these funds.

8) How much attention do the managers pay to the index, and to what extent are absolute returns important?

IBT’s managers operate a benchmark aware but not constrained approach to the benchmark index, the NASDAQ Biotechnology Index.

9) Does the investment trust use gearing and if so is it structural or opportunity led?

The IBT managers can use gearing up to 30% of NAV although, in practice, gearing rarely exceeds 15%. Gearing is deployed tactically, with the managers aiming to utilise it when they anticipate a period of enhanced returns

_{Disclosure – Non-Independent Marketing Communication. This is a non-independent marketing communication commissioned by International Biotechnology. The report has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on the dealing ahead of the dissemination of investment research.}

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