This blog post continues our expert analysis of complex investments.
One of the most closely watched valuation metrics for equities, equity funds, and indices is the price-to-earnings (“P/E”) ratio. The higher the price of the investment for a given level of earnings, the higher the P/E ratio, and vice versa.
The P/E ratio gives insight into the price an investor has to pay to buy the earnings of a given investment. It is useful as a metric to make comparisons between different investments and the same investment over time.
iShares Biotechnology ETF (IBB)
However, when investing in the iShares Biotechnology ETF (“IBB”), the reported P/E ratio of 39.62 differs materially compared to the average P/E of its largest holdings. Amazingly, when calculating the P/E ratio of the IBB, Blackrock does some strange things. Indeed, the fact sheet states that, “negative earnings are excluded, extraordinary items are excluded, and P/E ratios over 60 are set to 60.”
The table below shows the actual P/E ratios of the top 10 largest holdings in the IBB.
Table 1. iShares Biotechnology ETF Top 10 Component Analysis
Thus the actual P/E ratio of the top ten holdings of the IBB is 54.33, not 39.62. A difference of over 37 percent. However, the discrepancy is even worse when accounting for all 122 companies in the IBB. Zerohedge analyzed all 122 IBB component companies and found that 86 of them had negative earnings. They calculated the P/E ratio to be 82.5, or roughly twice the reported P/E ratio.
IBB Price Decline after the Zerohedge Story
As the chart below shows, it appears that investors were unaware of this discrepancy, because after Zerohedge broke the story, the IBB price declined immediately by over one percent.
As we have discussed here, this is another example of how complexity can get baked into an investment in ways that would never occur to an investor (or an advisor) and would be very hard to find in the prospectus. The P/E ratio is one of the simpler valuation metrics used by financial advisors. If the IBB has an advertised P/E ratio of 39.62, but its largest constituents have a P/E ratio of 82.5, the investment might behave much differently than expected.
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 iShares Nasdaq Biotechnology ETF; Available at http://www.ishares.com/us/products/239699/ishares-nasdaq-biotechnology-etf; Accessed May 14, 2014.
 Source: Google Finance
 Zerohedge; “What Is the PE of the iShares Biotech ETF? It Depends on Whether You Read the Fine Print”; Available at http://www.zerohedge.com/news/2014-05-08/what-pe-ishares-biotech-etf-it-depends-whether-you-read-fine-print; Accessed May 15, 2014.