Public mutual funds have recently finished releasing their second-quarter reports for 2026.

While a massive amount of capital has been flowing into the AI sector, the pharmaceutical sector has seen its overall size shrink. However, specific segments like innovative drugs and CXO have attracted increased bottom-fishing investments.

According to China Merchants Securities, the total scale of pharmaceutical funds stood at RMB 331.5 billion by the end of Q2 2026, a quarter-on-quarter decrease of RMB 22.3 billion from the RMB 353.8 billion at the end of Q1 2026. Non-pharmaceutical active funds' allocation to the healthcare sector has dropped to approximately 4.51%, a historically low level.

Looking at the holding structure, active pharmaceutical-themed funds increased their allocation to innovative drugs to 37% in the second quarter, making it their largest position. Traditional pharmaceuticals and CXO accounted for 30% and 24% respectively. Together, these three categories represent 90% of the active pharmaceutical fund holdings, showing increased concentration.

In non-pharmaceutical active funds, the allocation to innovative drugs, CXO, and traditional pharmaceuticals was 1.5%, 1.3%, and 1.1% respectively, with innovative drugs and CXO also being key positions.

A Consensus Forged from Decline

Before this consensus formed, innovative drugs had been in a period of stagnation for several months. From January to June 2026, the Shenwan Pharmaceutical and Biological Index cumulatively fell over 10%, significantly underperforming the CSI 300 Index by 17.81 percentage points, ranking 16th among 31 Shenwan primary industries.

From a valuation perspective, by the end of the second quarter, the price-to-sales ratio of the Sci-Tech Innovation Drug Index had retreated from its peak to the median level. The significant reduction in institutional holdings and crowded trades, combined with the industry's broad growth potential, provides ample margin of safety for medium to long-term positioning.

On the industrial front, a series of License-out transactions have been completed. The counterparties have shifted from small and medium-sized biotechs to the top 10 global pharmaceutical companies. The transaction targets have upgraded from me-too innovations to new drugs with first-in-class potential. The deal structures have also evolved from one-time sales to deep partnerships including sales royalties. The pricing of Chinese innovative drug assets by top global pharmaceutical companies is now far higher than the secondary market valuations in A-shares and Hong Kong stocks.

Against this backdrop of a significant valuation gap between primary and secondary markets, incremental capital with a long-term view on innovative drugs is quietly accumulating at the bottom. This behavior of "buying more as prices fall" stands in stark contrast to the trend-chasing buying at the end of the 2021 pharmaceutical bull market. After market sentiment reaches extreme pessimism, the room for valuation compression narrows considerably, and some capital convinced by industrial trends begins tentatively seeking entry points.

Research from GF Securities also confirms this trend:

Based on public fund holdings, after excluding the impact of stock price declines, the sectors that saw actual net capital inflows in the second quarter include pharmaceuticals, industrial metals, energy storage and lithium batteries, brokerages, and some domestic demand alpha stocks. Among these, innovative drugs and CXO accounted for a relatively high proportion.

Threefold Drivers

If the formation of a bottom consensus stems from "declining sufficiently deeply," then the recent strengthening of the innovative drug sector is the result of a confluence of three factors: policy, fundamentals, and capital flows.

Policy: Institutional Breakthroughs and Payment Expansion

On July 9, the 2026 edition of the National Essential Drug List (NEDL) was officially released. Its most notable feature is the inclusion of innovative drugs in bulk for the first time. The NEDL's positioning has upgraded from a single focus on "ensuring basic needs" to "ensuring basic needs plus promoting innovation." Simultaneously, the 12th round of volume-based procurement (VBP) has clarified the policy direction of "swapping cages for birds." It is estimated that this round of VBP will free up approximately RMB 50 billion in medical insurance fund space, specifically for the payment of innovative drugs. The funds freed up by VBP will effectively support market expansion for innovative drugs. Payment-side policies continue to provide incremental surprises beyond expectations, serving as a stronger domestic fundamental anchor beyond the initial rebound repair.

Fundamentals: Better-than-Expected Performance and Recovery in Sentiment

In Q2 2026, the fundamental recovery of the innovative drug sector was better than expected, with high sentiment in the CXO space. In the CDMO segment, new orders signed in the second quarter were at a high level of activity, and demand is expected to continue in Q3. The volume growth of oral peptide formulations has exceeded expectations, which is likely to drive the industrial chain's growth for the next 3-4 years. The CRO segment is benefiting from the recovery of overseas financing, and leading companies may see upward revisions to their full-year performance guidance.

Capital Flows: Seesaw Effect Providing Liquidity

The intraday negative correlation between innovative drugs and tech-related indices remains high. Recent weakness in sectors like semiconductor equipment and chips, along with a market style rotation, has provided additional liquidity space for the pharmaceutical sector.

Overall, with the recent pullback in the tech sector from its highs, capital is re-evaluating the risk-reward profiles of various sectors. Innovative drugs, with their strong earnings certainty, clear industrial trends, and low valuations, have become one of the preferred choices for some capital.

Rebound or Reversal?

This is a point of considerable market disagreement. To answer it, one should first return to a basic judgment: the recent rise is primarily a typical oversold bounce. Earlier market pessimism was excessive, valuations were compressed to extremes, and the combination of the tech pullback and positive policy catalysts triggered a repair in stock prices. However, whether this rebound can evolve into a reversal still depends on whether more sustainable fundamental driving forces emerge.

Qiu Xiaoxu, fund manager of the Cathay Innovative Healthcare Fund, believes that looking ahead to Q3 2026, in the short term, the most certain areas in the mid-year reports will still be innovative drugs and the innovative drug supply chain. Upcoming conferences like WCLC and ESMO are worth looking forward to, and valuations of related companies remain below historical averages. In the medium term, 2027 will see Chinese innovative drugs and innovative medical devices enter the phase of overseas commercial volume growth. Valuations of leading companies are significantly lower than their overseas peers, making the investment model easier to understand. This could attract continuous increased positions from funds across the entire industry. In the long term, the leapfrog progress of deep aging, the sustained recovery of the macroeconomy, and the diversification of medical payers will systematically drive the recovery of various pharmaceutical sub-sectors. Pharmaceutical investment is re-entering a phase where many segments can outperform.

Regarding specific sub-sectors, Qiu Xiaoxu stated that the fund will continue its Q1 holding structure, focusing on forward-looking growth. It will keep overseas commercialized innovative drugs as core holdings, alongside emerging industries like brain-computer interfaces and medical AI. In terms of balancing trend and contrarian investments, it will maintain overweight positions in the innovative drug supply chain, including high-sentiment new molecular mode CDMOs like peptides, bispecific antibodies, and ADCs, as well as efficiency, toxicology, and other aspects related to the rapid R&D validation of overseas BD-oriented new drugs. It will also focus on innovative devices and high-end medical equipment with increasing global penetration.

From a market rhythm perspective, Ma Yiwen, fund manager of the Cathay Sci-Tech Innovation Drug ETF, believes that current pharmaceutical sector investment could adopt a prudent approach of "accumulating positions in batches on dips." There are still some risk factors for innovative drugs in the second half of the year. Investors should focus on the industry's growth logic and valuation cost-effectiveness rather than chasing short-term rebounds.

From the quiet accumulation of capital in the bottom region during Q2, to the qualitative shift signals of primary market BD transactions, and then to the triple resonance of policy, fundamentals, and liquidity, the pharmaceutical sector—especially innovative drugs and CXO—is undergoing a process of expectation reshaping. Although the market path will not be smooth, and short-term rebounds may alternate with medium-term bottoming processes, the upward direction of the industrial trend is becoming increasingly clear. For investors willing to trade time for space, this may be a stage that requires patience and conviction—waiting for value to return as fundamentals are realized during the process of consensus building.