Healthcare is one of the most difficult sectors in which hedge funds invest. In this article, we'll see what they're buying today.
Healthcare investing is guarded by two major gatekeepers that combine to form a higher barrier-to-entry than perhaps any other sector: a steep scientific-medical knowledge curve and a complex regulatory environment.
The knowledge curve is even steeper at the clinical-stage, where share prices are based on trials data and regulatory approval, in contrast to other sectors where the drivers are economic and business fundamentals. Hedge funds that specialize in the sector must overcome the above research challenges, as well as investment risks such as elevated volatility. Together, these reasons explain why half of the healthcare specialists sampled in this article are led by an MD or PhD.
A recent example of the specialization paying off is Valeant–while for generalists, VRX is considered to be ‘the worst trade ever,’ very few healthcare specialists held the name. In this article, we’ll analyze the public data of 44 hedge funds that specialize in healthcare to understand how they’re investing in the sector.
Starting in early 2012, the iShares NASDAQ Biotech Index ETF (IBB) outperformed the iShares Dow Jones US Healthcare ETF (IYH) by a large spread, posting nearly uninterrupted gains for 3.5 years, until a ~25% correction in the second half of 2015. The correction was broad: 87% of securities in the IBB had negative returns during the period Jun 2015 through Jan 2016, but the index has continued to rise post drawdown.
The performance, even considering the drawdown, elevated the weight of Biotech companies from roughly 10% in 2012 to 20% of the broader Healthcare sector at present.
To determine how hedge funds are positioned, we selected equity hedge funds with consistently high exposure to Healthcare and simulated a portfolio that holds the combined 13F holdings.
First, the funds were equally weighted, with quarterly rebalancing. We then excluded any non-Healthcare sector securities and positions less than 2% of a fund’s public portfolio, to focus on meaningful positions. Finally, the remaining positions’ weights were scaled to sum to 100%. These are the specialists:
Since 2015, Healthcare specialists have allocated over 50% of their capital to Biotech.
Healthcare Areas of Focus
We tagged each biotech or pharma company by their Healthcare focus. This pie chart is a breakdown of the top five areas. The green contains all areas that each account for less than 2% of the portfolio. The grey are non-biotech/pharma companies such as insurers or service providers. Oncology is the clear heavyweight.
There are six different Healthcare focus areas represented in the portfolio’s top ten positions. It’s important to note that while we list the primary healthcare focus, companies can be involved in multiple areas, such as Gilead and Biogen, who are also working on Oncology. An interesting observation is that for the top positions of a biotech majority portfolio, only one of the top positions is a small cap name (< $2 billion).
Looking at a time-series of exposure to Oncology-focused companies, its again near the highs of 2013.
We then tagged each Oncology company by their approach. The key observation is the growing exposure to companies researching and investigating Immuno-Oncology (IO) solutions.
Half of the capital allocated to Oncology is now invested in companies involved in Immuno-Oncology.
The medical community’s improved understanding of the immune system and its applications within Oncology represents a significant shift in cancer treatment, which has been dominated so far by a combination of chemotherapy, surgery, and radiation.
Immuno-Oncology aims to activate immune cells to recognize and destroy cancer cells instead of targeting cancer cells directly, as chemotherapy does (IO may also be used in tandem with traditional chemotherapy or radiation). Biotech companies are focusing on two primary types. The first type customizes treatment for each patient by extracting immune cells from the patient, genetically modifying them to attack cancer, and then infusing them back into the bloodstream. The second type (much more common) are drugs (checkpoint inhibitors) which free existing immune cells to fight cancer by blocking a checkpoint that cancer uses to turn off the immune system response.
“This is a fundamental change in the way that we think about cancer therapy,” said Dr. Jedd Wolchok, Chief of Melanoma and Immunotherapeutic Services at Memorial Sloan Kettering. (NYT)
“I divide pharmaceutical companies into two categories,” says Drew Pardoll, Co-Director of Immunology at Johns Hopkins. “They’re in immunotherapy up to their eyeballs, or they want to be.” (WSJ)
Two of the portfolio’s largest IO positions, Incyte and Seattle Genetics, have attracted not only healthcare specialists (especially Baker Brothers), but also brand name hedge funds such as Citadel, Viking, Adage, and Alyeska. Celgene Corp has also gained the confidence of Adage, as well as Sachem Head, Point72, Tiger Management, Balyasny, and PointState.
While the benefits are emerging, some patients do experience harsh side effects. The immune system may attack healthy organs and patients will require steroids like prednisone to counter the immune response. That said, IO generally doesn’t cause the severe side effects typically associated with chemotherapy.
One side effect of chemotherapy, CINV (Chemotherapy-Induced Nausea and Vomiting), is a large problem for patients post treatment and for doctors trying to optimize dosage. Its noteworthy that two of the top three chemotherapy focused companies in the portfolio don’t make chemo drugs; they are producers of Antiemetics.
Heron Therapeutics and Tesaro are entering a playing field dominated by big pharma. Heron’s Sustol (extended-release granisetron) was approved by the FDA in August 2016, and was launched later that fall. It works in a similar way as GlaxoSmithKline’s commonly used Zofran. Heron hopes its clinical candidate Cinvanti (aprepitant) will be approved in late 2017. Cinvanti could be used together with Sustol, which may lower costs and drive adoption of both. In addition to our Healthcare specialists, funds such as Carlson, Citadel, Balyasny, and Tourbillon are also invested.
Tesaro’s Varubi could be used in combination with Merck’s Emend, which is widely used in hospitals. In addition to our Healthcare specialists, Point72, Senator, Alyeska, and Citadel are invested, as well as prominent venture capital firm Kleiner, Perkins, Caufield & Byers.
One limitation in our measurement of the oncology exposure is that major or diverse biotech/pharma companies who have oncology partnerships or internal oncology departments weren’t tagged as oncology (ex. AstraZeneca, Bristol Meyers Squibb, Merck) due to their many other business lines and sources of revenue. The charts above are more representative of the portfolio’s exposure to “pure play” oncology focused companies. The true exposure is even higher.
Managed Health Care – Insurers
Hedge funds weren’t phased by Federal Judges blocking the proposed mergers of both Aetna-Humana in January and Anthem-Cigna in February. These four insurers were all top five positions within Managed Health Care, each with a larger position size than giant UnitedHealth.
YTD, the four insurers have outperformed (by a large spread) both UNH and the S&P 500 Health Care Index.
Aetna and Anthem were also large increases from Q4 to Q1.
Volatility and Concentration
The portfolio’s majority weight to biotech resulted in a six-month rolling standard deviation of similar to that of the biotech index, and much higher than the broader Healthcare index.
This volatility has likely restricted the sizing up of positions, with almost no position above 3% during the analysis period. Liquidity is critical when holding positions at these levels of volatility, and it’s no surprise that only one of the portfolio’s top ten positions is a small-cap. The rest are above the $2 billion market cap threshold.
Healthcare specialists are now allocating the majority of their capital to biotechnology. Oncology is the top area of investment, with roughly 20% of the portfolio invested in Oncology-focused companies. Positive results from Immuno-Oncology solutions has led to a similar weighting in those companies compared to traditional Chemotherapy researchers/producers. Neurology is also a key area to monitor, as the growth in its exposure is accelerating. Outside of biotech and pharma, exposure to insurance providers has tripled. Finally, the sector’s characteristic volatility has limited concentration in any one name to under 3% of the portfolio.