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Buying into the Biotechnology Bonanza

Looking at biotech funds? We'll tell you what you need to know.

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Move over Internet stocks, biotechnology firms are the newest market darlings. Over the past 12 months, the average biotech fund has returned an astonishing 237%.

With the recent surge, investors are tripping all over themselves to catch a piece of the action. If you're thinking about joining the biotechnology frenzy, here are a few things you should know first.

There's No Cure for Cancer Yet
Don't be fooled by those recent mouthwatering returns: Biotechnology will continue to be volatile. Biotech stocks experience boom and bust cycles--although these highs and lows seem to be driven more by investor momentum and sentiment than by fundamentals.

In 1991, when the sector was all the rage, Fidelity Select Biotechnology (FBIOX) was the third best performing offering in the mutual fund universe, returning 99% for the year. But if you'd gotten into the fund on January 1, 1992, you would have been in for a rude surprise: Over the next three years, it posted an average loss of 9.6% each year.

Since then, the sector has experienced another boom, another bust, and yet another boom. What drives these cycles? It's pretty simple: unbridled enthusiasm followed by widespread disappointment.

That doesn't mean that all biotech companies are trading on sheer speculation. The most recent rally, for instance, which started in late 1998, was at first driven by impressive new therapies coming to market, including Immunex's (IMNX) arthritis drug Enbrel and Biogen's (BGEN) promising multiple sclerosis treatment.

But as this rally drags on, investors are bidding up many of the industry's tiny companies that are years away from revenues or earnings. These are the firms most susceptible to dramatic downturns on unfavorable news in clinical trials--an all too common occurrence.

Should you avoid the sector altogether? Not necessarily. But the first rule of biotech investing is that you must be prepared for extreme volatility.

A Road Map for the Brave
Okay, so you've decided you're aggressive enough to invest in biotechnology. The next question is: What fund should you buy?

There are only five dedicated biotechnology funds in the Morningstar universe, and one of them, Franklin Biotechnology Discovery (FBDIX), is closed to new investors. Here's a primer on the remaining four:

Dresdner RCM Biotechnology (DRBNX): This fund is suddenly the belle of the ball, thanks to the impressive returns generated by fast-trading manager Faraz Naqvi. The fund is up 349% over the trailing 12 months--trouncing all other biotech funds. Naqvi's portfolio is a mixture of established biotech names such as Biogen and IPOs such as Maxygen (MAXY). But investors should approach this fund with caution. Naqvi has only been at the helm since April 1999, and he's had the wind at his back since he started.

Fidelity Select Biotechnology (FBIOX): The granddaddy of biotech funds, this offering has been around since 1985. Compared with the rest of the field, Fidelity Select Biotech is fairly conservative. Its managers invest heavily in the big biotechnology companies such as Genentech (DNA) and often pepper the portfolio with a handful of pharmaceutical holdings such as Merck (MRK). Thus, the fund will likely be less volatile than its hyperaggressive rivals, and it can look a little slow when the smallest biotech names are soaring. A good choice overall, though.

Monterey Murphy New World Biotechnology (MNWBX): Until early 1997 when it changed its mandate, this was a gambling and leisure fund. According to its most recent available portfolio, the fund invests in a mixture of biotechnology and blue-chip pharmaceutical stocks and has a huge stake in S&P 100 options. Until recently, it hadn't performed very well. It gained only 21% in 1999 while the other four biotech funds gained an average of 95.8%. Frankly, there's not a whole lot that's appealing here.

Rydex Biotechnology (RYOIX): Designed to be a market-timing vehicle, this is a quasi-index fund. Its managers invest in about 70 stocks on a capitalization-weighted basis. The result is a portfolio that is heavily skewed toward the biggest biotech names; the fund's top 10 names take up 75% of assets. Again, not for the timid. The fund's $25,000 minimum can be avoided if you buy through a fund supermarket such as Schwab.

Looking Further Afield
Because there are few dedicated biotechnology funds, investors might consider a more diversified health-care fund that invests heavily in the biotech sector, such as Janus Global Life Sciences (JAGLX), Firsthand Medical Specialists (MSFQX), and Invesco Health Sciences (FHLSX).

These funds are appealing because their fortunes are tied less directly to the biotech sector. If investor enthusiasm for genomics companies begins to flag, the funds will have more flexibility to look elsewhere.

The Janus fund, for instance, has a hefty stake in biotechnology but also holds a variety of other stocks including eye-care firm Allergan (AGN) and medical-device giant Medtronic (MDT). The fund is just a baby, but the power of Janus' growth-savvy investing has been evident in its success thus far: It's up 72% so far in 2000. Its main drawback is the fund's rapidly growing asset base, which could prevent manager Tom Malley from investing in biotech's smaller names.

A Few Reminders
Beware of gimmicks. Just because a fund has "genomics" or "medical" in its name doesn't mean it's an appealing investment. If you want a health-care fund, look for one with a long track record, preferably one that's proved itself in a variety of markets. If you're looking at a young fund, it's better to consider one offered by an established fund family, where you can be reasonably confident that a team of experienced analysts is backing the portfolio manager.

Don't put all your eggs in one basket. Investing your entire portfolio in biotechnology because it's hot right now is a bad idea, plain and simple. If you want to invest in biotech, put a small amount of your assets in a fund, preferably less than 5% of your portfolio.

Don't buy more than one biotechnology or health-care fund. While there are some differences among biotechnology funds, they all invest in a similar basket of stocks. If you buy more than one fund, you'll likely be buying most of the same stocks twice.

Consider dollar-cost averaging. Because biotechnology is volatile and many of the stocks are trading at heady multiples, you might be better off putting a small amount of money into your fund on a regular basis rather than just one lump sum.

Emily Hall does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.