Commentary: Revolutionizing health and wealth — the untapped investment potential in biotech innovations

In the realm of investment opportunities, biotechnology stands out as a rapidly evolving field with immense potential. Over the past two decades, groundbreaking advances in biotechnology have not only transformed healthcare, but have also presented unique investment opportunities. Innovation shifts and scientific breakthroughs have opened doors to promising investment avenues that are often overlooked and unexplored by mainstream investors.

It's no secret that advances in biotechnology have materially improved human life in new ways. After first being achieved in 2002, the cost of sequencing an individual genome has declined from over $1 million in 2008 to under $1,000 today and revolutionary medicines have followed. Children with previously incurable diseases like spinal muscular atrophy can now lead more normal lives, survival rates for many cancers have improved dramatically, and developments in areas such as immunotherapy now offer hope where there previously was none. Despite these remarkable advances, it's often overlooked how little exposure most investors have to these game-changing therapies and the economic windfalls they can bring.

Historically, the development of novel therapeutics predominantly occurred in university laboratories or within the extensive research and development divisions of large global pharmaceutical companies. However, as these entities often struggled with allocating capital in a well-organized way across their widespread research initiatives, public market investors increasingly advocated for a reduction in R&D spending. Instead, the focus shifted toward enhancing efficiency and profitability from already approved therapies and utilizing cash flow for the distribution of stable dividends. As a result, much of this R&D effort has been pushed into many smaller, independent firms where incentives and rewards can be better aligned for talented researchers pursuing potentially groundbreaking science. This shift is vividly illustrated by the dramatic surge in the number of small and midcap biotechnology firms publicly traded in the United States. From just 250 in 2003, their numbers have swelled to over 600, representing a market capitalization of over $600 billion and accounting for one-seventh of all publicly traded firms today.

Despite this vast public footprint, these innovative firms are lightly represented in the broad market indexes that tend to anchor most investor portfolios. The Russell 3000 index, for example, which offers broad-based exposure to U.S. equities, has less than a 0.5% weighting to this area, while the technology and innovation heavy Nasdaq 100 index has no exposure. Furthermore, investing in individual stocks is generally not advisable for most investors considering that the median market capitalization of each public biotech firm is small, and an investor needs deep scientific expertise to effectively evaluate the clinical ventures of each company. This makes it exceedingly difficult for investors to smartly build exposure to this exciting and potentially highly profitable area.

We believe that a portfolio approach is an effective strategy. This involves aggregating exposure by investing through several highly skilled, aligned, and appropriately sized biotechnology specialist investors. Given that each specialist manages a concentrated portfolio reflective of his or her unique investing style and capabilities, combining these portfolios can provide diversified exposure without significant overlap. This method can allow for a diversified yet focused investment in the biotech sector, that capitalizes on the expertise of various specialists. For example, while one specialist might gravitate toward long-term winners seeking to capture potentially large new therapeutic areas, another might gravitate toward fallen angel investments trading at or below the value of cash on the balance sheet. Each style has merit and the potential to generate outsized returns; and if the two approaches don't overlap, the excess returns should be fundamentally uncorrelated. In this manner, investors would be able to craft a portfolio where potentially high and uncorrelated outperformance from the specialist partners add to return but also help to materially reduce the volatility of the inherent underlying sector exposure. We believe this approach offers a way for investors to correct a somewhat systemic portfolio underweight and more prudently obtain much larger exposure to the exciting developments taking place in biotechnology today.

The biotech sector presents a compelling investment opportunity that extends beyond traditional market indexes. Unique investment potential can be gained through the sector's growth which is driven by independent firms and ground-breaking research. By adopting a strategic portfolio approach and by leveraging the expertise of multiple biotech specialists, investors can smartly navigate this sector which is complex but rewarding. This approach not only allows for participation in cutting-edge health innovations, but also positions investors to potentially reap significant economic benefits.

Niels Peetz-Larsen and Adam Posner are both principals at HighVista Strategies, based in Boston. This content represents the views of the authors. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I's editorial team.