Biotechnology is one of those sectors fraught with potential and peril at the same time. Pick the right company developing the right drug at the right time and the stock will reward shareholders. Conversely, any bad news regarding a company’s clinical trials can quickly put shareholders in the red.

Given the inherent risk involved in owning individual biotech names and the fact that many biotech companies currently lack sufficient cash to stay in business beyond 2010, biotech ETFs may be a better way to play this sector.

There are currently six biotech ETFs. Each differs in their stock holdings and indexes they follow, and each has its pluses and minuses. Some hold a small number of stocks, some a large number, and others may be weighted heavily toward one or two individual names. Let’s take a look at the group to see if there are ways to profit beyond just owning the big biotech stocks like Amgen (AMGN) and Gilead Sciences (GILD).

iShares Nasdaq Biotechnology Trust (IBB) (fund overview) follows the Nasdaq Biotechnology Index and holds the largest number of stocks of any of the ETFs highlighted here. Current holdings number 123, but the cap-weighted methodology puts 98 of them at less than 1% weighting. IBB has an expense ratio of 0.48% and is more actively traded than the other five biotech ETFs combined. It gets my vote as the best trading vehicle in the group.

HOLDRS Biotech ETF (BBH) suffers from structural problems. It is not a true ETF but a “grantor trust” and as such cannot alter its underlying holdings except as a result of corporate actions. This produces lopsided holdings over time – current holdings include Amgen (AMGN) at 35.7%, Gilead Sciences (GILD) at 31.4%, and Biogen Idec (BIIB) at 15.0%, totaling 82.1%. It can also lead to undesirable consequences, such as the nearly 50% distribution created by the recent acquisition of Genentech by Roche Holdings. I do not recommend BBH for either investment or trading purposes.

SPDR S&P Biotech (XBI) (fund overview) follows the S&P Biotechnology Select Index and currently holds 25 equally weighted stocks. Its high level of diversification (for a sector fund), and low expense ratio of just 0.35%, make this ETF a viable player in the biotechnology space. However, it is relatively new, having been introduced in 2006, and therefore does not have as large a following as IBB and BBH.

First Trust Amex Biotechnology Trust (FBT) (fund summary) tracks the performance of the NYSE Arca Biotechnology Index (formerly called the AMEX Biotechnology Index). FBT holds 20 stocks, equally weighted with quarterly rebalancing. However, due to the varied performance of the underlying stocks, the weightings can change dramatically every quarter. Its largest holdings at this time include Human Genome Sciences (HGGI) at 9.1% and Affymetrix (AFFX) at 7.4%. It is the top year-to-date performer of the group with a +5.4% gain as of 6/12/09. However, it does not have a large following with an Average Daily Value Traded (ADVT) of only about $400,000. The net expense ratio is 0.60%.

PowerShares Dynamic Biotech & Genome Portfolio (PBE) (fund overview) is based on a quantitative index from Intellidex, which evaluates companies on a variety of investment merit criteria. The tier weighting methodology ensures that the largest companies do not dominate the fund and allows smaller companies to contribute to overall performance. PBE holds around 30 companies. Since some of those are small cap names, this can be a way for investors to get some of the benefits associated with small biotech firms while mitigating part of the risk with more familiar sector names. PBE began trading four years ago (June 2005) and has a net expense ratio of 0.63%.

PowerShares Global Biotech Portfolio (PBTQ) (fund overview) follows both domestic and foreign biotech companies, although 78% of its current holdings are U.S. companies. This ETF was launched in September 2008, making it the newest of the bunch. It has failed to gain acceptance in the market and is on ETF Deathwatch. PBTQ has an expense ratio of 0.75%.

The biotechnology industry is officially part of the broader health care sector, although it often has relatively low correlation with health care. Biotech peaked in March 2000, culminating a spectacular run that began in late 1998. As is the case with most sectors and industries, it has gone through many periods of being in favor and out of favor. Biotech ETFs vastly outperformed the S&P 500 from June 2008 through February 2009, but they have lagged since then.

Even though it has lagged during the recent market rally, iShares Nasdaq Biotechnology Trust (IBB) has done about +20% better than the S&P 500 for the past twelve months. It has also outperformed SPDR Select Sector Health Care (XLV), the most widely followed diversified health care ETF, for the past one, three, and five-year periods.

Disclosure: no positions