Risk and Reward in the Orphan Drug Industry ANDREW W. LO AND RICHARD T. THAKOR ANDREW W. LO ABSTR ACT: Thanks to a combination of TOPICS: Mutual funds/passive investing/ is the Charles E. and Susan scientific advances and economic incentives, the indexing, security analysis and valuation, T. Harris Professor at development of therapeutics to treat rare or orphan performance measurement* the MIT Sloan School of Management, director of diseases has grown dramatically in recent years. the MIT Laboratory for With the advent of Food and Drug Administration– Financial Engineering, approved gene therapies and the promise of gene he term orphan disease typically and a principal investigator editing, many experts believe we are at an inflec- refers to rare conditions that affect at the MIT Computer tion point in dealing with these afflictions. In relatively small patient popula- Science and Artificial this article, the authors propose to document this tions, such as amyotrophic lateral Intelligence Laboratory in inflection point by measuring the risk and reward Tsclerosis, chronic myelogenous leukemia, Cambridge, MA, and an external professor at the of investing in the orphan drug industry. They and Gaucher disease. Many are fatal or Santa Fe Institute in Santa construct a stock market index of 39 publicly traded extremely debilitating. Although any single Fe, NM. companies that specialize in developing drugs for orphan disease is by definition uncommon, [email protected] orphan diseases and compare the financial perfor- it is estimated that there are over 7,000 types mance of this index, which they call ORF, to the of such diseases and that the population of RICHARD T. THAKOR is an assistant professor broader biopharmaceutical industry and the overall Americans with an orphan disease ranges of finance in the stock market from 2000 to 2015. Although the from 25 million to 30 million, exceeding the Carlson School of authors report that ORF underperformed other bio- total number of US cancer patients. Management at the pharma companies and the overall stock market in Until the passage of the Orphan Drug University of Minnesota the early 2000s, its performance has improved over Act (ODA) in 1983, the biopharmaceutical in Minneapolis, MN. [email protected] time: from 2010 to 2015, ORF returned 608%, industry showed little interest in developing far exceeding the 317%, 320%, and 305% returns therapies for orphan indications: In the of the S&P, NASDAQ, and NYSE ARCA Bio- decade before the ODA, only 10 industry- tech indexes, respectively, and the 83% of the S&P sponsored orphan drugs were brought to 500. ORF does have higher volatility than the market in the United States. However, thanks other indexes but still outperforms even on a risk- to various economic incentives created by the adjusted basis, with a Sharpe ratio of 1.24 versus ODA (e.g., tax benefits, extended exclusivity, Sharpe ratios of 1.17, 1.14, and 1.05, respectively, and priority Food and Drug Administration for the other three biotech indexes and 0.71 for the [FDA] review), combined with technolog- S&P 500. However, ORF has a market beta of ical breakthroughs such as efficient whole- *All articles are now 1.16, which suggests significant correlation to the genome sequencing and rational drug design categorized by topics and subtopics. View at aggregate stock market and less diversification ben- methods, over 600 orphan drug indications IPRJournals.com. efits than traditional pharmaceutical investments. were approved by the FDA between 1983 and 30 Risk and Reward in the Orphan Drug Industry July 2019 2017, based on more than 450 distinct drug products.1 higher volatility than the pharma index, indicating In a number of cases, fatal conditions such as chronic substantial risk. Although the volatility is slightly myeloid leukemia and Gaucher disease have been trans- higher than that of the biotech index, it moves closely formed into chronic but manageable conditions with with that index. The volatility of these indexes has the appropriate medication. Moreover, the advent of shown a secular decline since 2000 and also has less gene therapy now holds the promise of cures for certain dispersion compared to the early 2000s. However, the orphan diseases, of which 80% are genetic in origin. higher volatility in the early 2000s may be due to the These factors have contributed to what many con- bursting of the tech bubble. sider to be an inflection point in the treatment of orphan Market betas for the ORF and biotech indexes diseases, reflected in the financial performance of the in general decreased between 2000 and 2010, spiked biopharmaceutical companies producing orphan drugs. between 2012 and 2013, and have since been declining. A case in point is Alexion Pharmaceuticals, a US com- The betas of the ORF and biotech indexes are quite sim- pany founded in 1992 that received FDA approval in 2007 ilar over time, but when calculated over longer horizons, for Soliris, a treatment for paroxysmal hemoglobinuria, ORF has the higher beta beginning in 2005. The pharma a rare blood disorder. Since its initial public offering in index consistently posts lower betas than the ORF or 1996, Alexion has yielded an average compound annual biotech indexes. The conclusion is that orphan drugs return of 29% (through August 10, 2018); on May 24, carry significant systematic risk relative to the market. 2012, the stock was added to the S&P 500 index. Of In terms of downside risk, the maximum draw- course, not all orphan drug companies are as successful, downs of ORF are consistently greater in magnitude and even those companies that succeed to the point of than those of the other indexes (i.e., they are more nega- going public still bear considerable risk. The amount of tive), showing a potential for greater tail risk of negative risk and whether the returns to investors are commensu- returns for orphan drugs. The exception is the k-means rate with that risk are the subjects of this study. biotech index, which has comparable maximum draw- We propose to measure the financial performance downs. However, the drawdowns have been smaller of the orphan drug industry by constructing an index in magnitude (less negative) over time, indicating that of US companies that focus exclusively on developing there has been improvement. therapies for orphan diseases. We identify 39 such com- panies, construct a value-weighted return index with INDEX CONSTRUCTION AND EMPIRICAL these companies as constituents, and investigate the sta- METHODOLOGY tistical properties of this index, which we shall refer to as ORF. In the early 2000s, we find that orphan drug com- Our goal is to construct an index with companies panies as an aggregate were not as attractive an invest- that undertake pure-play orphan drug development. ment as other drug companies; that is, ORF had worse We therefore define an orphan drug company as returns with substantially higher risk. However, ORF’s performance has improved over time. During the last 1. a company that has an expressed and exclusive five years, ORF has outperformed both the pharma and commitment to the development of orphan drugs biotech sector indexes in terms of risk–return profile. (as determined by their mission statement); Overall, an investment in orphan drug companies from 2. a company that is devoted specifically to one or 2000 to 2015 would have fared better than an investment more orphan disease areas; or in either pharma or biotech, even after adjusting for risk.2 3. a company whose pipeline consists only of orphan It is useful to compare ORF to other indexes in drugs. the biopharmaceutical sector. ORF has consistently To identify the set of constituent companies for 1 Lanthier (2017). See also Lichtenberg and Waldfogel (2003), our index, we obtain the entire history of orphan drug who documented increases in consumption and longevity for indi- designations to date from the FDA’s Orphan Drug viduals with less common diseases after the passage of the ODA. Designation and Approvals database.3 From this history, 2 Our results are also consistent with recent evidence that suggests that orphan drug designations can serve as a positive signal for stock market investors at the time of an initial public offering; 3 FDA Orphan Drug Designations and Approvals Database: see Gorry and Useche (2018). https://www.accessdata.fda.gov/scripts/opdlisting/oopd/. July 2019 The Journal of Portfolio Management 31 we identify all companies that have achieved orphan NASDAQ indexes—as well as widely used pharma and drug status for at least one product. From these compa- biotech indexes, including the NYSE ARCA Pharma, nies, we manually identify the subset of companies that NYSE ARCA Biotech, NASDAQ Biotech, and S&P adhere to our definition of an orphan drug company. 500 Biotech.5 However, as noted by Thakor et al. (2017), This yields a total of 170 companies, of which 39 are US a significant concern with comparing biotech indexes is publicly traded companies. The complete list of compa- the substantial sensitivity of their return characteristics nies that we consider, as well as the dates for which we to the inclusion of specific companies, a result of the out- have data, are included in the Appendix. sized performance of a handful of companies. Thus, for For these companies, we obtain daily stock return comparison we also include k-means pharma and bio- data from the CRSP database from January 3, 2000 to tech index returns taken from Thakor et al. (2017), who December 31, 2015. We choose 2000 as our starting year classified companies into the pharma or biotech sectors because that is the first year that includes a quarter with dynamically over time using observable characteristics 10 or more orphan drug companies from which we can via machine learning techniques.6 construct our index.