How to Play Biotech Without Getting Burned

With merger activity heating up in the biotech space, we thought it would be useful to discuss the best ways for individual investors to participate in the action. As with any cutting-edge technology industry, huge potential upside mingles with potential disaster in biotechs. After a relatively quiet showing in 2007 (3% total return), the Amex Biotechnology Index (^BTK) is up almost 7% year-to-date (through Aug. 25)--not too shabby considering the S&P 500 Index is down about 12.5% over the same period. So what's behind the recent action in the biotech sector?

The answer: big pharma is on the prowl. It is no secret that mature drugmakers flush with cash and drying pipelines are looking to bolster their anemic growth by targeting smaller firms with promising drugs and innovative research-and-development programs. (For more on this, check out our recent Video Report). For example, on the heels of Roche's (RHHBY) pursuit to acquire the remaining portion of  Genentech  that it doesn't already own (see our Analyst Note), we saw  Bristol-Myers Squibb (BMY) make an offer to acquire  Imclone  (see our Analyst Note). While this signals that the trend of big pharma firms looking to build out their pipelines via acquisitions is alive and well, we'd note that this trend has been building over the past few years. Take for instance  GlaxoSmithKline (GSK) buying Sirtris,  AstraZeneca (AZN) buying MedImmune,  Merck's (MRK) purchase of Millennium, and  Wyeth  buying Haptogen.

So naturally, the question now becomes: Who will be next? And more importantly, how can we, as investors, profit from the interest in merger activity?

While our skilled health-care equity analysts have identified some potential takeout candidates ( Onyx  and  Amylin Pharmaceuticals , to name a couple), even they aren't 100% sure which biotech firm will be the next to see its stock price get bid up by takeover premiums. (Click here to read a recent Stock Strategist article from our health-care team suggesting that the best way to gain exposure to the biotech sector is through basket of stocks.) Luckily for investors, there are ETFs out there that provide the means to cost effectively add baskets of potential biotech takeout targets to a standard portfolio. Investors seeking exposure to this lucrative but volatile subsector of health care need look no further than  SPDR S&P Biotech (XBI),  iShares Nasdaq Biotechnology (IBB), and  PowerShares Dynamic Biotech & Genome (PBE), which have posted year-to-date gains of 17.89%, 9.76%, and 6.14%, respectively, through the end of July. Despite its strong recent performance, we'd be inclined to take a closer look at the SPDR S&P Biotech ETF, as Onyx and Amylin are both top 10 holdings, making up 4.21% and 4.24% of the fund's assets, respectively.

Though fertile grounds for merger activity and explosive potential upside can attract investors to biotech stocks, violent declines are commonplace in this industry when a potential blockbuster drug fails to pass regulatory clinical trials or harmful side effects are discovered and litigation ensues. That's why we'd be inclined to invest in the sector via ETFs; we can sleep better at night knowing we have diversified. Take for instance the recent events at  Biogen Idec (BIIB) and  Elan , which in a few short days saw their market capitalizations slashed by 28% and 70%, respectively (note that Biogen Idec is a top 10 holding in each of the three biotech ETFs listed above). The culprit: News surfaced that two cases of a fatal side effect from their multiple-sclerosis drug, Tysabri, were discovered in Europe. This is a great example of the diversification power that ETFs offer; the abovementioned ETFs still delivered impressive returns despite their exposure to both Biogen-Idec and Elan.

Whether it's the upside reward investors are trying to capture or the downside protection, the biotech sector is a great example that highlights the advantages sector ETFs offer investors.