Risks and Rewards of Investing in Biotech Hedge Funds

In the last two decades, the U.S. biotech sector has grown to become one of the stock market’s top performing sectors. Due to its rapid growth and potential for high rate of return, there has been a recent wave of investor interest in biotechnology and biotech hedge funds. Many new investors in the biotech sector are excited for fast-growing investment funds capable of generating double- and triple-digit returns. Yet other investors remain wary, stating the high risks, potential for massive loses and the lackluster performance of the average hedge fund in current years as deciding negative factors.

So, what exactly are the risks and rewards of biotechnology-focused hedge funds, and should you be interested?

Biotechnology, broadly speaking, is any technological application that makes or modifies products or processes using biological systems. Currently, there are over 500 biotech companies in the U.S., making it the world’s hub for innovation in the biotechnology field; however, only approximately 20 of these 500 are turning a profit. This is due to the uncertain nature of the biotech sector. High overhead costs, long periods of research and testing, plus the uncertainty of final regulatory approval by the FDA (Food and Drug Administration) mean that, in terms of stock market valuations, it’s very difficult for investors to predict with any certainty which biotech companies will strike it big and which will fall by the wayside.

For the biotech industry, while politicians and the political climate have some impact on drug pricing, due to “high intra-industry variance,” biotech stock prices chiefly rise and fall based on a drug passing or failing its clinical trials. This makes the biotech sector extremely volatile and unpredictable, at best, for most investors and uninvestable, at worst, for others. However, therein lies the opportunity for those willing to bear the risk.

Those investors who have been successful say that they chose funds which specialize in small- to mid-size biotech companies – those whose fate hinges on the successful pass or fail of a single drug test – while avoiding big pharmaceutical companies, insurance conglomerates or hospital chains. Successful funds were also highly diversified and employed research analysts experienced in the biotechnology field.

Yet some hedge fund veterans, like Joseph Edelman who founded Perceptive Advisors and its flagship hedge fund, Perceptive Life Sciences Fund, back in 1999, have struck big by specializing in small- and mid-cap biotech companies. Since inception, the fund has generated annualized gains of 30% net of fees, with an astounding 41% net gain realized in 2017.

Edelman has thrived in the most volatile sector of the stock market by being highly diversified with the companies he backs; avoiding big pharmaceutical companies, insurance conglomerates and hospital chains, instead backing small companies whose fate typically hinges on a single drug passing or failing the clinical trials – a high-risk strategy that returns big rewards if successful; maintaining risk tolerance and timing his purchase of stocks accurately between Phase 1 clinical trials and, often, Phase 3 clinical trials; and understanding the major innovations currently taking place in the biotech field.  His unique background, which includes a degree in psychology from UC, San Diego, and a father who was a professor of biochemistry and later chair of the molecular chemistry and biophysics department at Columbia University, certainly helped develop his industry acumen.

Edelman says of his own strategy that careful research into the companies he selects, taken together with the ability to understand and psychologically analyze corporate events within the biotech sector, is the driving factor behind his alpha generation.

This correlates with what researchers have found when studying rate of returns within the biotech sector. It is healthcare-specific hedge funds, those with background knowledge of biotech or those specifically focused on the healthcare and biotech sectors, which statistically have the most success in accurately predicting which drugs and companies will succeed and which will fail.

John Zoraian John Zoraian is a Principal in Grassi’s Financial Services practice, where he provides expert fund administration, compliance and advisory services to hedge and private equity funds, funds of funds, master-feeders, investment advisors, broker-dealers, family offices, fintech entities and more. John draws from more than 35 years of experience in the hedge fund business. Prior to joining Grassi, he established S&Z Fund Services, a division... Read full bio

Categories: Advisory