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By Bloomberg

Breakthrough treatments targeting rare diseases are paying off for shareholders.

The S&P 500 Health Care Index is the best performer of 10 industry groups in the Standard & Poor’s 500 this year and has produced the best risk-adjusted returns since December 2009, according to the BLOOMBERG RISKLESS RETURN RANKING. The group, which includes Merck & Co., Gilead Sciences Inc. and Pfizer Inc., returned 10.4 percent over the past five years after adjusting for price swings, compared with the 6.7 percent gain for the S&P 500.

The boom stems from the development of specialty drugs to treat rare diseases and particular cancers. Vertex Pharmaceuticals Inc., whose shares have surged about 62 percent this year, said in June it has a pair of drugs that improve lung function in patients with cystic fibrosis. Gilead, which makes a breakthrough treatment for the treatment of hepatitis C, has surged 41 percent this year. Much of the development is the fruit of decoding the genome a decade ago, said Marshall Gordon, a health-care analyst at ClearBridge Investments.

“We’re really seeing the payoff from a lot of basic science that was completed 10 years ago, and a lot of that’s genetics,” Gordon said in a phone interview. “If you look more broadly, pharma has done extremely well, and so has biotech, in large part because there’s been massive clinical success.”

Higher Prices

Targeted drugs produced by companies such as Vertex and Celgene Corp. can drive profit by commanding high prices, according to John Schroer, sector head of U.S. healthcare at New York-based Allianz Global Investors.

“With improved genetic testing you can identify specific markers that create an additional level of specificity,” Schroer said in a phone interview. “Because you’re limiting the addressable patient population, and with greater efficacy in that population, you can command premium pricing.”

Though generic drugs constituted 86 percent of prescriptions in the U.S. last year, brand-name medications drew 71 percent of pharmaceutical spending, according to a study by IMS Institute for Healthcare Informatics. Almost 70 percent of brand spending was on specialty drugs, according to the paper, a gain of 7.7 percent from 2012.

Eighteen cancer drugs introduced in the past five years cost more than $10,000 a month, according to data from Memorial Sloan-Kettering Cancer Center. A cholesterol-lowering treatment for those with certain rare genetic disorders costs $311,000 a year, and a cystic fibrosis medicine -- developed partly with funding from a charity -- costs $300,000 annually.

Mergers, Acquisitions

A demand for premium drugs has spurred mergers and acquisitions in the industry. More than $443 billion in pharmaceutical deals have been sealed so far in 2014, five times the value of transactions that were completed or pending during the same period last year, according to data compiled by Bloomberg.

Attempts to elude the U.S.’s high corporate tax rate has also helped fuel the rate of deals, according to Allianz’s Schroer. In this year’s biggest deal, Actavis Plc last month agreed to pay about $66 billion for Allergan Inc. Actavis, which keeps its operational headquarters in Parsippany, New Jersey, keeps its tax address is in Dublin, which offers a lower rate.

New drugs can demand high prices because they’re often the only game in town, according to Ziad Bakri, a biotechnology analyst with T. Rowe Price Group Inc. Gilead’s Harvoni, which treats hepatitis C, is one such drug, he said.

Breakthrough Cure

“Back when I was in medical practice hepatitis C was something that essentially couldn’t be treated,” Bakri said in a phone interview. “All of a sudden you have a cure for hepatitis C, a pill. You take it for three months and it cures hepatitis C.”

That cure doesn’t come cheap -- it costs $94,500 for a typical 12-week treatment on the medication. Harvoni is the first drug that can treat the vast majority of patients without injections or another standard therapy called ribavirin, the U.S. Food and Drug Administration said.

Risk-adjusted returns, which aren’t annualized, are calculated by dividing total gains or losses by volatility, or the degree of daily price-swing variation, giving a measure of income per unit of risk. Higher volatility means the price of an asset can swing dramatically in a short period of time, increasing the potential for unexpected losses compared with a security whose price moves at a steady rate.

Damping Volatility

Though smaller biotechnology firms have remained volatile, companies such as Johnson & Johnson and Abbott Laboratories helped damp price swings in the health care index. The firms, the two least volatile on the index, are less reliant on breakthrough drugs and made more than half their revenue last year from products like medical devices and consumer goods. Balanced by such firms, the health-care index was among the least turbulent S&P industry groups, with a volatility score about 19 percent lower than the average.

The industry’s risk-adjusted return over the past five years was about 1 percentage point above the next-best performer, consumer staples. The energy index ranked as the worst performer on an adjusted basis over the past five years.

Regeneron Pharmaceuticals Inc., the maker of eye medicine Eylea, was the best performing company on the S&P health index since Dec. 9, 2009, with a cumulative return of more than 2,178 percent in that period.

Regulatory Approval

Regulators are speeding up the approval of some drugs under a new proposal that became law in July 2012, a development that will help companies trying to bring new treatments to market. Pharmaceutical companies can request the agency designate their experimental treatments for serious or life-threatening diseases as breakthrough therapies. Through last month, 10 drugs had been approved for the breakthrough fast-track this year, according to the U.S. Food and Drug Administration, including Gilead’s Harvoni.

“The FDA and the EMA have taken a more accommodative stance,” said ClearBridge Investments’ Gordon, referring to the European Medicines Agency. “Particularly for some of these hotter areas you’re seeing the approval process move, and in a good way.”