Biotech Funds Follow the Ugly Script of Tech Funds

Investors who gorged themselves on sizzling biotech funds last year are learning the same lesson as those who stuffed billions into tech funds: Money that flows into a hot subsector often shows up just in time for a vicious beating.

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After a sizzling 1999, shares of biotech firms surged as battered investors fled the buckling tech sector. These cutting-edge drug shops' shares were already trading at frothy valuations, but they climbed even higher, helping health care funds trounce the market with a 55% average gain, compared with a 9.1% loss for the S&P 500. That led to a $13.5 billion geyser of cash into health funds last year, nearly tripling the old record, according to Boston fund consultancy Financial Research.

But now biotech stocks, as well as other health care subsectors, have come crashing back to earth. For fund investors, the upshot is twofold: First, it's always a good idea to keep sector-fund investments to less than 10% of your portfolio to limit risk. Second, you should be wary of subsector funds whose losses can be as breathtaking as their gains, a cycle biotech stocks and funds are in right now.

"Last year was shocking, the whole sector was highly valued," says Emily Hall, who covers health care stocks and funds at Morningstar, a financial research house in Chicago. "I think the main problem with biotech heading into this year is that the stocks were just very overvalued and that's very dangerous."

Dangerous, indeed. Hall points to biotech shops like Human Genome Sciences(HGSI), where hopes appear to have gotten a bit too high. The firm is a big player in the exciting business of figuring out our genes and using that information to develop remedies. The unprofitable company, which probably won't have products on the market for at least a couple of years, gained 329% in 1999 and another 81% last year. It's selling at more than 200 times its sales, according to Morningstar, and its shares are down 37% so far this year.

The average health care fund has already lost more than a quarter of its value this year. Over the last 12 months the average health fund is in the red to the tune of nearly 12%, despite last year's gains.

2001: A Sick Odyssey Health funds have fallen hard this year

Source: Morningstar. Returns through March 23.

While the health sector in general is down this year, biotech stocks are leading the charge south. The American Stock Exchange Biotechnology Index is down nearly 30% already this year, after gaining 62% and 111% in 2000 and 1999, respectively, according to Baseline/Thomson Financial. Even a biotech bellwether like Genentech(DNA) is down more than 40% already this year.

Biotech Leads the Charge in the Wrong Direction Biotech stocks have fallen like, well, tech stocks this year

Source: Baseline/Thomson Financial. Returns through March 23.

While all health care funds are in the red since Jan. 1, those focusing strictly on biotechnology stocks have been hit hardest. The average health care fund might be down some 26% so far this year, but the average health fund focusing on biotech is down nearly 37% over the same period, according to Morningstar. (Later today, I'll offer a screen of funds for investors shopping for a solid health care fund that spreads its money around the sector.)

A look at the 10 hardest-hit health funds over the last year turns up a slew of biotech funds, some of which have a genomics or health sciences label.

Simply Red It's been a tough 12 months for biotech funds
Health Fund	1-Year Return	2000 Return
(GENEX)GenomicsFund.com	-54.2%	N/A
(MSFQX)Maketocracy Medical Specialists	-41.9	-0.7
(FBDIX)Franklin Biotech Discovery	-40.3	46.6
Janus Aspen Global Life Sciences	-37.9	N/A
(ORHAX)Orbitex Health & Biotechnology	-35.2	56.2
(FBIOX)Fidelity Select Biotechnology	-34.8	32.8
(RYOAX)Rydex Biotechnology	-34.2	28.0
(MFMAX)Monument Medical Sciences	-33.6	34.1
(MNWBX)Monterey Murphy New World Biotech	-33.2	64.0
(DRBNX)Dresdner RCM Biotechnology	-30.1	81.9
Average Health Care Fund	-8.4	55.4
S&P 500	-24.5	-9.1
Source: Morningstar. Returns through March 23.

These extreme losses illustrate the old saw that sector funds should be just 5% or 10% of your portfolio and subsector funds are usually not a good idea for most investors. With a shorter menu of stocks to choose from, these laser-focused funds tend to perform more like stocks than funds, which entails more volatility than most fund investors want.

"If you're going to buy a sector fund, focus on one with lower expenses and one that casts a fairly wide net," says Morningstar's Hall. "There are a lot of really good reasons for broader diversification within a sector and as an analyst, I don't really like nichey funds."

Keep in mind that choosing a sector fund that spreads its money around a sector doesn't mean it can't perform well. As we pointed out earlier this month, even with their recent losses, a diversified portfolio with a 10% allocation to the average health care fund would've still consistently beaten the market over the past one-, three-, five- and 10-year periods.

Of course, those figures are probably little solace to all those investors who bought shares of a health fund last year. They weren't the only ones chasing the sagging sector's performance, though; roughly one-third of the 43 health funds out there have launched since the start of 2000. Fund companies have either launched or filed paperwork for five health funds in the last two months.

It's an Epidemic Over the last two months, fund companies have rolled out a handful of new health funds
New Health Fund	Launch Date
IShares Nasdaq Biotechnology Index	Feb. 2
Turner Health & Biotech	Feb. 28
John Hancock Biotechnology	March 1
Wells Fargo Specialized Health Sciences	March 19
Oak Health Sceinces	June 1
Source: Freeedgar.com, MaxFunds.com and fund company Web sites.

The Junk Pile

Looks like the migration of mutual fund managers to the more lucrative world of hedge funds happens in bad times as well as good.

Remember last year when a slew of tech- and growth-fund managers packed up after 1999's fat returns and bolted to run hedge funds, which give them a fat cut of the fund's profits and often a bigger paycheck? Fidelity lost Erin Sullivan and Andrew Kaplan, while Frank "Quint" Slattery left PBHG Funds and Brian Stansky quit at T. Rowe Price.

That made sense because these folks' valuations were essentially the same as tech stocks', and neither could get much higher. But now some managers might start looking at their sagging portfolios and be eager to start their own hedge fund where they can have a clean slate and be freer to sell stocks short; shorting stocks allows you to profit when their prices fall.

This year John Schroer dropped the reins of the struggling Invesco Global Health Sciences fund, a closed-end fund soon to adopt an open-end structure. He left to start his own hedge fund shop, Itros Capital. And just last week, Jeff Wrona left the (PBTCX)PBHG Technology & Communications fund, where the firm's aggressive, earnings-momentum style had led to big losses. Over the last 12 months the fund is down 75.9%, trailing 90% of its peers, according to Morningstar.

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