Some view skyrocketing biotechnology stocks as a bubble, but hedge funds are riding optimism on companies in the sector to monster gains—for now.
Stock prices for biotech indexes stand at all-time highs, having gained more than 350 percent over the past five years, a rate that's more than triple the broader stock market.
Hedge funds have joined the party, piling into the relatively volatile sector. Top names owned by funds include large drug makers like Amgen, Biogen and Regeneron focused on creating medicine from living cells instead of chemicals. Investors have also cashed in on stocks like Synageva Biopharma, Dyax and Bluebird Bio, relatively small or unproven companies whose pipeline of products can get big returns if they make it to market with government approval.
Those bets have been money makers for private investors. Hedge funds that focus on biotech or invest in the sector as part of a broader health-care portfolio have produced average gains of 20.87 percent over the last five years, according to an analysis of 50 funds by Simplify, which tracks hedge fund return data and consults on risk management.
"It's an extremely hot sector for investing right now," said Simplify CEO Brian Shapiro.
This year, the group has gained an average of 9.7 percent in the first quarter, making biotech the best performing hedge fund strategy in 2015, with the exception of niche funds that focus on Chinese and Russian stocks; hedge funds that focus on U.S. stocks are up about 2 percent this year, according to HedgeFund Intelligence.
Big winners include venBio Select Fund (up about 22 percent through April); Broadfin Healthcare Fund (21.5 percent through March); Rhenman Healthcare Equity L/S Fund (up 19.44 percent through April); EcoR1 Capital Fund (up 18.61 through March); Stonepine Capital (up 17.66 through April); and Perceptive Advisors (up 11.8 percent through April), according to performance information obtained by CNBC.com.
Biotech investing was a tiny strategy until sector stocks took off after the financial crisis. With more hedge funds investing in the area—and lots of companies going public to choose from—some say those with less experience could get burned.
"When prices rise like this, the majority of investors come in too late, they pay too much, they're long only—and they end up catching the brunt of any issues," said Jacob Gottlieb, founder and chief investment officer of $6.9 billion Visium Asset Management.
Gottlieb, a medical doctor by training, runs the health-care-focused Visium Balanced Fund, a $4.7 billion strategy launched along with the firm in 2005 that has produced annualized returns of 15.2 percent net of fees, according to performance information obtained by CNBC.com.
Unlike many hedge funds in biotech that focus on stock gains, Visium's health-care fund has a roughly even weighting of shorts against stocks with the so-called long bets. It's up 7.53 percent through April this year.
Gottlieb said he's positive on companies that are working on products related to Alzheimer's disease and oncology. But he also noted that "valuations are high" and "there's a lot of opportunity on the short side" if a company's products don't perform as expected.
"There's definitely opportunity in the space," Gottlieb said. "I'm very optimistic for the prospects for doing good work and analysis going forward whether the market goes up or down."
Others are also hunting for biotech stocks to bet against.
"There is a lot of emotion in the market at present. We continue to view health-care stocks as expensive across all subsectors," Michael Castor, founder and portfolio manager of health-care-focused Sio Capital Management, wrote in a recent letter to investors.
Castor said that Sio, founded in 2006, is 15 percent net short today, meaning that the value of its bets against stocks outweigh its longs. It is also net short biotech stocks specifically and considers immuno-oncology products to treat cancer as the area of the most hype.
Another to bet against biotech companies is Kyle Bass' Hayman Capital Management. The high-profile hedge fund manager recently unveiled a new strategy to short the stocks of health-care companies like biotech Acorda Therapeutics while simultaneously challenging their patents to key drugs, something called Inter Partes Review.
Others note continued opportunity in biotech.
Robert Christian, who analyzes hedge funds as head of research at K2 Advisors and Franklin Templeton Solutions, said biotech stock-focused managers stand out as one of his favorite strategies among the few dozen he tracks.
Christian's optimism rests on what he called exciting new technologies that justify higher company valuations.
"Biotech used to be about making life a little better. Now it's often about saving it. People will pay anything for that. That makes the opportunity set so much larger," he said.
While Christian noted managers must be analyzed individually, he said he generally "feels good" about risk management by biotech hedge funds and "not nervous" about hedge funds having too much risk should the market correct.
Investors seem to agree, adding about $1.4 billion in net new capital to health-care hedge funds over the last three years, according to eVestment, which tracks hedge fund assets and performance. Such funds managed $25.46 billion as of March 31, slightly less than their peak in the third quarter of 2007 ($27.15 billion).
New funds are also launching at least in part to take advantage of the biotech opportunity. Firms that recently began trading or are about to include Orchard View Capital Advisors and Goldwater Asset Management from SAC Capital Management alums Eric Evans and William Hoh, respectively, and Ikarian Capital from Neil Shahrestani of Pura Vida Investments.
The biotech stocks held by the most hedge funds are Gilead, Celgene, Biogen, Amgen and Alexion Pharmaceuticals, according to public data as of March 31 compiled by Symmetric, which analyzes and compares hedge funds based on such filings.
On the short side, Regeneron, Celgene and Amgen are the largest negative bets held by hedge funds as of March 31, according to a Goldman Sachs report.