Investors in biotech have the potential to reap tremendous rewards, but at the same time, the risk can be enormous -- sometimes in the same stock.

For example, an investor in Neurocrine Biosciences ( NBIX) could have gotten into the stock below $5 in 1999. Neurocrine topped out at $73 in March of this year.

However, after the FDA failed to approve its insomnia treatment Indiplon and after partner Pfizer ( PFE) walked away from the drug, Neurocrine's stock crashed, closing Wednesday at $9.23.

Mutual funds have long been a preferred method for investors to diversify their holdings, but there aren't too many biotech-oriented options. I found 10 funds that invest most of their assets in biotech. Several others have significant exposure to the sector but also invest heavily in medical devices, pharmaceuticals and health care stocks.

Christopher Davis, a fund analyst with Morningstar, suggests one of these broader health care funds for investors who want exposure to biotech. That way, a negative ruling by the FDA on a biotech stock doesn't wreck your portfolio. He points to ( PRHSX) T. Rowe Price Health Sciences as one of his favorites. Of the fund's portfolio, 43% is invested in biotech stocks.

"It has a more aggressive approach and looks for faster-growing companies than some of its competitors," he said. As of March 31, four of its top five holdings were biotech -- Gilead Sciences ( GILD), Amgen ( AMGN), Genentech ( DNA) and Cephalon ( CEPH).

That's pretty much what you'll find in most biotech funds, and ETFs for that matter, says Davis, and that is why he recommends avoiding the sector-heavy funds to begin with.

"Chances are, you have exposure to these companies through your other mutual funds," he says. "Every large-cap growth fund owns Amgen and Genentech."

Plus, the mutual funds in the sector tend to be expensive. The ones that aren't appear to have managers with less-than-stellar track records.

Take the ( FBIOX) Fidelity Select Biotechnology fund. It has the lowest expense ratio, 0.97%, of the 10 funds and a better performance for the year to date, last three years and past five years. The five-year return is a loss of 0.21%, but that's up against the average loss of 1.33%.

Manager Rajiv Kaul ran the Select Biotech during the late 1990s, when the fund exploded higher under his tenure. However, when he assumed control of two midcap growth funds, his performance was unimpressive. One fund badly trailed its peers, and another simply matched the performance of those in its category, according to Morningstar.

Kaul has decreased his exposure to some of the largest holdings in Select Biotech while spreading the wealth around to some smaller names such as Myogen ( MYOG), which makes therapies for cardiovascular disease.

Despite the manager's track record in nonbiotech funds, Fidelity's offering is probably the best of the group because of its low cost and manager's experience.

Unfortunately, the other decent funds have sky-high loads or minimum investments. ( ETHSX) Eaton Vance Worldwide Health Science sports a 5.75% load and a 1.56% expense ratio, meaning you would need to be a long-term holder to make this one worth your while. Over the past five years, the fund has gained 3.06%. Only three out of eight funds with five-year track records have advanced over that time period.

The Eaton Vance fund is 70% invested in biotech, and the rest is in pharmaceutical makers like Novartis ( NVS) and Schering-Plough ( SGP).

The key to Eaton Vance's success is manager Sam Isaly, who heads Orbimed Advisors. Isaly has been investing in health care companies for nearly four decades. He runs hedge and private equity funds along with the Eaton Vance fund. While allocating his share of assets to the large-caps such as Amgen and Genentech, the manager prefers to invest in smaller names that may not even have products in the marketplace.

Companies like Crucell ( CRXL), a Dutch developer of vaccines and antibodies with a $793 million market cap, are in the mutual fund's top 25 holdings. Crucell lost $19 million in 2005, its sixth consecutive annual loss. No Wall Street analysts cover the firm. But it's this kind of company that has the most potential to provide the fund with peer-beating performance.

Of course, those companies are also fraught with risk, but while traveling potentially rocky roads, a guide like Isaly is very helpful. The question is whether it's worth 5.75%.

( RYOIX) Rydex Biotechnology is a quantitative fund, but you need $25,000 to invest. There are other classes with lower minimums, but you'll pay a deferred load and an outrageous 2.36% expense ratio.

Even the main fund's 1.34% expense ratio seems a bit high, considering investment decisions are left to mathematical formulas as opposed to research on drugs and marketplaces. Year to date, the fund is down more than 10% and has underperformed on a three- and five-year basis.

Raging biotech bulls with a bunch of cash who want to speculate can consider ( BIPIX) ProFunds Biotechnology UltraSector. This fund requires a $15,000 minimum, but if biotech does well, the fund should do exceptionally well.

ProFunds Biotech seeks results that correspond to 150% of the Dow Jones U.S Biotechnology Index. No surprise, then, that year to date the fund is off more than 14%. Its three-year return of 8.86% is nearly double its peer average. Keep in mind that Amgen makes up 24% of the portfolio and Genentech another 11%.

Another Way

There are four biotech ETFs. If your goal is exposure to the sector without the heavy influence of the large-caps, your best bet is probably the new SPDR Biotech ( XBI). While it's not yet terribly liquid, its low expense ratio and focus on mid-cap stocks make it a more likely candidate for significant upside.

The ETF's largest holdings include MannKind ( MNKD), a cancer and diabetes therapeutics company with no meaningful revenue, and Cubist Pharmaceuticals ( CBST), which makes treatments for skin infections. Genentech doesn't show up in the holdings until No. 16.

Overall, only your speculative money should probably find its way to the biotech sector. With the ability to lose half its value on a single news item, the risk to an individual stock is considerable. Even the mutual funds are susceptible to significant haircuts.

Considering the expense and likely redundancy, investors are probably better off putting their money in a growth fund that holds a considerable amount of Amgen or Genentech or a broad health-sector fund like T. Rowe Price Health Sciences. Then, if you want to swing for the fences, keep a little on the side for individual ideas.
Putting Biotech Funds to the Test
Here's how they compare
Name Symbol Expense Ratio Load YTD Return 3 Yr Return 5 Yr Return Min Inv. Notes
Allianz RCM Biotechnology DRBNX 1.60% None -9.21% 1.13% -1.89% $5,000 56% of assets in top 10 holdings
Eaton Vance Worldwide Health Sciences ETHSX 1.56 5.75% -4.62% 4.16% 3.06% $1,000 70% invested in biotech
Fidelity Select Biotechnology FBIOX 0.97% None -4.45% 5.44% -0.21% $2,500
Franklin Biotechnology Discovery FBDIX 1.25% 5.75% -8.77% 5.23% -0.71% $1,000
Genomics Y GENEX 1.90% 2% deferred -8.23% 5.82% -6.76% $5,000 $7 mil in assets. Genentech 13% of portfolio.
Live Oak Health Sciences LOGSX 1.15% None -12.68% 5.06% 1.56% $2,000 $29 mil in assets. Diversified but majority invested in biotech.
ProFunds Bio. UltraSector BIPIX 1.58% None -14.50% 8..86% 0.61% $15,000
Quaker Bio. Pharma Healthcare CBPCX 3.06% None -6.08% 3.54% N/A $2,000 Class A has 5.5% load with 2.31% exp ratio
Rydex Biotechnology RYOIX 1.34% None -6.81% 3.86% -1.97% $25,000 C class has $2,500 min with 1% def load and 2.36% exp ratio.
Saratoga Health & Biotechnology SHPAX 2.70% 5.75% -11.23% 2.22% 5.63% $2,500 C class has $10K min with 1% def load and 3.3% exp ratio.
Average 1.70% -8.66% 4.50% -1.33%
Source: Morningstar

In keeping with TSC's editorial policy, Lichtenfeld doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships.

Marc Lichtenfeld was previously an analyst at Avalon Research Group and The Weiss Group and a trader at Carlin Equities. He holds NASD 86,87, 7 and 63 licenses. His prior journalism experience includes being a reporter/anchor for On24 in San Francisco and a managing editor of InvestorsObserver, a personal finance Web site. He is a graduate of the State University of New York at Albany. He appreciates your feedback; click here to send him an email.

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