The appeal of finding the right biotech stock is self-evident. If you get it right, and a cutting-edge biotech scores a major win with a breakthrough drug treatment, then you can score huge gains.

Last month, I reviewed my performance over the course of 2011 in hopes of gleaning important new lessons for the coming year. Chief among those lessons: avoid companies that will need fresh injections of capital to keep afloat. I singled out the biotech sector, which not only faces the prospect of an uncertain economic environment in which to raise money, but is headed by executives who are simply clueless about how Wall Street works. So many biotech stocks waited far too long to raise money that their shares have fallen 50% or even 75% in the past year on fears of a liquidity crunch by the time they finally raised needed funds. The dilution for these firms has been stunning.

The current year should bring more of the same. Many of these companies raised about a years’ worth of fresh capital in 2011 and will need to reload the balance sheet once again in 2012 — at likely depressed levels, implying even more painful dilution.

Sadly, for every biotech stock that takes off sharply, another half-dozen plunge to new lows because of nature of these cash-constrained business models.

Instead, it seems far wiser to simply own a basket of biotech stocks in order to gain exposure to this still-promising sector. This limits upside when compared with the potential of a single high-flying biotech company, but also greatly reduces risk.

Let’s take a look at a few options.

1. iShares Nasdaq Biotechnology Index (NYSE: IBB)
This fund is hitting all-time highs and isn’t really the right vehicle for those who want exposure to the most dynamic aspects of the biotech industry. It holds stakes in large well-established biotechs like Gilead Sciences (Nasdaq: GILD), Teva Pharmaceuticals (Nasdaq: TEVA), Celgene (Nasdaq: CELG) and others. These companies are increasingly becoming similar to Big Pharma stocks, as the top-line growth rates are no longer really impressive. The merger and acquisition (M&A) angle is always part of the broader biotech theme, but these biotechs are now so large that they are likely too big to be gobbled up by Big Pharma because of their existing market values.

A similar logic applies to the Market Vectors Biotech ETF (NYSE: BBH) and the ProShares Ultra Nasdaq Biotechnology ETF (NYSE: BIB). All of these funds are hitting their peaks and would have been a lot more appealing a year or two ago.

2. First Trust Amex Biotech Index (NYSE: FBT)
This fund moves down the food chain by owning more of the middle-tier biotech firms and has a smaller emphasis on the industry’s top players. For example, United Therapeutics (Nasdaq: UTHR), Nektar Therapeutics (Nasdaq: NKTR), and Illumina (Nasdaq: ILMN) are the top three holdings. The fact that Illumina has just received a buyout offer from Roche Holdings (Pink Sheets: RHHBY) tells you these companies aren’t too large to get caught up in the M&A cycle.   

 “[This fund] is skewed more toward smaller-cap, early-stage biotech firms (which have decidedly uncertain prospects but explosive upside potential). In fact, almost half of the names in this ETF are companies with no drug on the market yet.” Morningstar analysts note.  They recommend the fund, but note it brings high-risk along with high reward, adding that its exposure to “small-cap names to have a greater impact on returns, and this has helped the ETF’s returns outperform its peers in some periods.”

3. PowerShares Dynamic Biotech & Genome INtellidex SM index (NYSE: PBE)
This fund moves even further out on the risk curve, yet is more capable of delivering strong returns if investors flock to the speculative end of the biotech sector. Roughly half of the holdings are early-stage biotechs that have yet to land a drug on the market. As is similarly the case with other exchange-traded funds (ETFs) noted above, this fund carries an expense ratio of 0.63%, well below the fees sought by a biotech-focused mutual fund.

4. T. Rowe Price Health Sciences fund (Nasdaq: PRHSX)
As mutual funds go, this one’s 0.84% annual expense ratio isn’t too bad. Better still, the performance has been consistently good when you consider its fund manager takes positions in smaller, risker biotechs alongside the larger, more traditional picks. The fund rose 32% in 2009, 16% in 2010 and 11% in 2011. It gets a gold rating and four stars from Morningstar.

Risks to Consider: The funds that focus on smaller biotechs would take a real hit if the market turned south. For example, the T.Rowe Price fund noted above sank 29% in 2008 when the broader market hit the skids. As a result, the more speculative biotech funds should only be seen as long-term investments. In addition, the major biotech ETFs, which own the industry’s blue chips, are hitting fresh highs. Some of their key holdings may be ripe for profit-taking.

Action to Take –> Though the chance to score huge gains with just one biotech stock holds great allure, few investors manage to get it right and find the one stock that really breaks out. Instead, investors should go with the basket approach that these funds offer.

[Note: If you haven’t heard about this unique opportunity, then I want to tell you about it now. StreetAuthority has staked me with $100,000 of real money to invest in my absolute best ideas. For a limited time, you’ll be able to follow along with me completely free. Go here to learn more.]