The Best in Biotech

The sector's potential is limitless--but the profits, so far, are not. A mutual fund can help spread the risk wisely

New treatments for cancer. Stem-cell research that could one day yield replacement hearts and kidneys. A map of the human genome that scientists might use to tailor drugs to specific patients.

With such wonders of biotechnology hovering on the threshold, you may be tempted to invite some biotech stocks into your portfolio.

Before you do, consider that biotech can be extremely volatile, with many companies little more than research labs. Understanding the financial statements isn't enough. What matters is the success of the company's projects--whether a drug tested on animals will make it to human trials, how apt regulators are to approve a drug for sale. With more than 300 publicly traded biotech companies, only 47 have a product on the market.

So unless you have a PhD in molecular biology, you're better off investing through a mutual fund. An astute portfolio manager can do the research needed to separate the possible breakthroughs from the likely debacles. And, as with all mutual funds, your dollars are spread among scores of stocks, reducing the risk.

But even the best funds offer no guarantees. In 1999, biotech funds returned a dazzling 83.3% on average, according to Morningstar Inc. In 2000, they still managed to ring up 45.8%, as disillusioned tech investors migrated here for high returns not as vulnerable to economic slowdown. Through July 31, however, biotech funds have fallen 26.6%: Investors have lost some of their appetite for risk.

Of the 14 biotech funds followed by Morningstar, only a handful have invested in this area for at least three years. The Dresdner RCM Biotechnology Fund is one with impressive credentials. Its three-year annualized returns are 47.8%--including 111.4% for 1999 and 81.9% in 2000. The fund is managed by Faraz Naqvi, a Harvard Medical School grad with a masters in economics from Cambridge University, and Camilo Martinez, who has both an MD and a Phd in neuroscience from Harvard. Brainpower alone, however, is no defense against losses: The Dresdner biotech fund was off 28% in the first seven months of 2001.

LIMITED FOCUS. Naqvi and Martinez spread the fund's assets among some 60 companies, ranging from large, steady outfits such as Amgen Inc. and Genentech Inc. to volatile small ones with the potential to deliver massive gains--or losses. Its top holding is MedImmune Inc., the manufacturer of Synagis, a drug used to fight respiratory infection in infants.

Fidelity Select Biotechnology, the oldest biotech fund, is a bit less volatile since it holds larger companies. But that focus can limit potential returns: Its three-year average of 28.1% is high but trails Dresdner. And this year, the large-company tilt has not protected it from the downdraft. The fund lost 28.5% by the end of July.

Rydex Biotechnology looks less at the science, taking a more quantitative approach. It holds about 70 stocks, and, like an index fund, bases much of its decision on a company's market capitalization. That leaves nearly 60% of its assets in the 10 largest holdings. The fund's three-year average annual return is 37.5%. Another fund, Franklin Biotech Discovery A, has a strong record but is closed to new investors.

This year's biotech sell-off could be more a reaction to the general market than to this sector's outlook. Charles Hill, research director at Thomson Financial/First Call, says biotech is one of the economy's bright spots. First-quarter returns were up 41% from a year ago, he says. While the second quarter looks like it will be off 3%, the third and fourth quarters could see gains of more than 20%.

If so, that should perk up biotech stocks--and, of course, the mutual funds that invest in them.

By Carol Marie Cropper

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