The Most Famous Alpha You Never Heard Of

Biomedical investing has been en vogue off and on from the time Genentech went public in 1980.  In more recent memory, after emerging from the dark days of the Great Recession, investors have been exuberantly backing one biotech scientific breakthrough after another.   As is well-known, for several years after 2010, the Nasdaq Biotechnology Index tore ahead of the broader market and most other subsectors.

So could there be anything in biotech the investment community has not closely looked at? Well, evidently there is.  And it has been sitting right under everyone’s noses. A recent paper examines the possibility of biotech companies laying off their FDA regulatory risk by issuing “FDA Hedge” instruments. In “Sharing R&D Risk in Healthcare via FDA Hedges” (2017), a highly respected team of health economists and financial economists - Jorring, Lo, Philipson, Singh and Thakor  (henceforth JLPST) – examine the regulatory risk that is the stuff of everyday life at biotech companies.   

FDA Risk Appears Unrelated to Market Risk

In this paper, JLPST quietly make an assertion that should be considered nothing less than stunning. They have found a source of risk that is completely uncorrelated to market risk. In other words, they may have discovered a source of pure alpha. If it were not for the caliber and credibility of the authors of this paper, most of us would have dismissed this out of hand.

Designing Synthetic Binary Options based on Likelihood of FDA Approval

JLPST use data from the BioMedTracker Pharma Intelligence database which estimates likelihood of future FDA approval for individual drugs. The authors explain that BioMedTracker’s Likelihood of Approval (LOA) estimates are based on historical approval rates combined with analyst adjustments based on newsflow about the company and the drug. Based on the Likelihood of Approval (LOA),  JLPST construct synthetic binary options that offer a payout if the drug fails to gain approval. They work out returns for these synthetic options for all drugs in the BioMedTracker and then regress them to estimate CAPM and Fama-French 3-factor betas (i.e. market, size and value factors).  The betas are found to be insignificantly different from zero. 

Proximate Proof of Concept through M&A-related Contingent Value Rights

JLPST also look for proximate proof of concept for their idea of FDA Hedges from the real world. They review the performance of Contingent Valuation Rights (CVRs) issued by Celgene, Sanofi and Wright Medical Group, all of which have significant trading volume. These CVRs are exchange-traded instruments typically issued at the time of acquisition deals, usually as pre-specified investor payments when certain milestones are met. These milestones generally include FDA approval decisions. However, since CVRs often scramble up the milestones to include sales target achievements, these CVRs are not pure FDA Hedges.  JLPST regress returns on CAPM and Fama-French betas and once again find that the betas are insignificant, despite the fact that features such as sales target should imbue systematic risk. What is more, the daily and monthly returns of the 3 CVRs show insignificant correlation with each other, so there does not appear to be any other common factor that is not captured by CAPM / Fama-French factors.  

Some Concerns

JLPST modestly call their work a first step towards creating real-world FDA Hedges and indeed it is.  This reviewer would be cautious about at least 2 aspects. 

First, over their entire history, biotech stocks have fluctuated wildly, magnifying market ups and downs with supercharged, high-octane (market) betas. These ups and downs are often triggered by FDA approvals/rejections of bellwether pipeline drugs for biotech leaders such as Amgen. While JLPST’s work is very convincing and plausible, those who work directly in the field will find it hard to believe that FDA risk is not somehow entangled with market risk.   

Secondly, some analysts believe that the number of FDA approvals in any given year follows a “political cycle” – driven by political winds around regulation and deregulation, tied in turn to the relative strength of liberals and conservatives in the White House and Congress.   Even if this is untrue or at least not empirically documented, it would be hard to believe that broader political, economic and social trends have no influence on FDA thinking (see, for example, Harris 2012). So systematic risk should somehow play a role.

Conclusion

The above points of caution notwithstanding, JLPST’s paper is path breaking. If FDA risk differs from market, size value risks already known, it opens a new source of potential alpha. Options or other financial instruments constructed to hedge FDA risks will then of course be welcomed by investors hungry for diversification. It goes without saying that biotech companies will be equally eager to issue such instruments, since that will help to considerably de-risk their business models. One day, we may even think of stocks of FDA-hedged biotech companies as similar to those of boring utilities!  

JLPST should be thanked for isolating a source of alpha that many biotech investors are already intensely engaged with but never embraced in its own right. Sitting right under everyone’s noses, FDA risk may be the most famous alpha you never heard of.   

References

Jorring, Lo, Philipson, Singh and Thakor (2017), “Sharing R&D Risk in Healthcare via FDA Hedges”, NBER Working Paper 23344, April

Harris (2012) “White House and the FDA Often at Odds”, The New York Times, April 2