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One of the hottest sectors in 2012 has been the Biotechnology Sector, with the Nasdaq Biotechnology Index up 40.5% year to date as of October 3. For investing purposes, this sector is tracked by the iShares Nasdaq Biotechnology Index ETF (NASDAQ:IBB). The fund has done a good job tracking the index this year, coming in at a 40.7% gain including the small dividend it pays.

Biotech is a risky sector, with possibilities for large gains but periods of substantial declines. In its 10-year history, the IBB has incurred losses of 50% in 2002 and 35% in 2008-2009. The fact that it has recovered those losses and more attests to the desire of investors for these high growth names.

Breaking Down the IBB

The volatility of the IBB is reflected in the underlying stocks of the ETF. In order to spread some of the risk of the sector, iShares invests the funds of the IBB ETF in a large number of companies. 116 stocks were represented in the fund as of October 5, but the fund is somewhat top heavy, with 10 stocks making up 56.65% of the fund.

There are some large companies in the fund, and they are well-represented. The fund also invests a small portion of its resources in smaller companies that could be subject to wild swings based on FDA approval or denial of the company's products (or single product).

The following chart takes a look at the top five holdings in the fund:

Name and SymbolPercent of FundMarket Cap
Alexion Pharmaceuticals (NASDAQ:ALXN)8.8622.3B
Regeneron Pharma (NASDAQ:REGN)8.1814.7B
Amgen Inc. (NASDAQ:AMGN)7.8366.5B
Gilead Sciences (NASDAQ:GILD)6.7752.7B
Celgene Corp. (NASDAQ:CELG)5.6234.6B

As with most sector ETFs, the largest companies in the sector are well represented. A bit unusual is that the two largest holdings do not have the largest market capitalization. Alexion and Regeneron have smaller market caps but make up a larger share of the fund. Investors looking for diversification into the biggest biotechs are going to find that the fund is heavily weighted toward these companies.

That said, Alexion has had a year to date return of 64% over that period, and Regeneron has returned a 185% gain since the beginning of the year. A great choice, as it turns out, but is that really why an investor buys an ETF? If the fund was as heavily weighted in some other small biotech, they could have done much better or worse, but would have not have performed as investors would have expected.

If the fund had concentrated a disproportionate share on Celgene, a relative underperformer at 16%, investors would have been less happy with their returns.

What Happens Next to Biotech?

Based on history, biotechnology is hardly the place for conservative investors, but any investment that returns 40% in less than a year is ripe for a pullback.

Although the bigger biotechs are profitable, the two largest holdings in the fund, ALXN and RGEN have current P/E ratios of 114 and N/A, respectively. (N/A meaning it is not profitable.) A case can be made that there is too much froth in this particular fund. If you have been lucky enough to hold this, it is likely time to scale back, and not to initiate a new position here.

Source: What's Growing Inside This Biotechnology ETF?