Wall Street’s next bet: Cures for rare diseases by Andrew W. Lo @FortuneMagazine January 21, 2014, 1:23 PM EDT E-mail Tweet Facebook Google Plus Linkedin Share icons What if I told you about an investment fund that diversifies your portfolio, shields you from fluctuations in the stock market, and earns double-digit returns? Sounds interesting, right? Did I mention that this investment also creates potentially life-saving treatments for deadly rare diseases? This fund doesn’t exist — at least not yet. I’m cautiously optimistic, however, that in the near future we’ll see the launch of an orphan disease “mega-fund” that finances early-stage biomedical research and drug development and is also a tidy investment. It works like this: The fund pools a large number of drug development efforts into a single financial entity or “mega-fund.” With the lower risk that comes from investing in multiple drug trials simultaneously, the fund yields a more attractive risk-adjusted return on the investment and a higher likelihood of success in finding cures for diseases. This, in turn, enables the fund to raise money by issuing “research-backed obligations” or RBOs, bonds guaranteed by the portfolio of possible drugs and their associated intellectual property. Because RBOs are structured as bonds, they appeal to fixed-income investors, who collectively represent a much larger pool of capital and who have traditionally not been able to participate in investments in early-stage drug development. This fund needn’t be big. In fact, in some recent research, my co-authors and I found that a fund of only $575 million may yield double-digit expected rates of return with only 10 to 20 projects in the portfolio. Admittedly, half a billion dollars isn’t chump change, but it’s not a lot of money in the world of pension funds, hedge funds, and other institutional investors. And at a time of historically low interest rates, this fund represents a practical investment that’s not very highly associated with the stock market and that is capable of generating attractive returns. So why now? A little background: Orphan diseases — which are defined by the Orphan Drug Act of 1983 (ODA) as illnesses that affect fewer than 200,000 people in the U.S. — were once anathema to the pharmaceutical industry. Drug companies thought it was a waste of time to develop drugs for such a small patient population; there simply wasn’t enough money there. MORE: Wall Street’s secret society is more secret than ever Today, things are different. This once-neglected category of diseases, which includes cystic fibrosis, Duchenne muscular dystrophy, and amyotrophic lateral sclerosis (more commonly known as Lou Gehrig’s disease), commands a market worth nearly $90 billion a year. What’s more, rare diseases aren’t as rare as we may think. They’re believed to affect more than twice the number of all U.S. cancer patients! At least 25 million Americans are afflicted with one of almost 7,000 orphan diseases. What has also changed is that we’re now better at treating orphan diseases. A combination of technological advances pioneered by scientists, biotech entrepreneurs, big pharma, and key insights from the Human Genome Project now allows us to identify the underlying causes of many of these disorders. And because these diseases afflict a narrow range of individuals, their mutations have similar pathologies and are therefore simpler to pinpoint. No longer are you looking for a needle in a haystack, you’re looking for a needle in a basket of straw. For a number of reasons, orphan drugs are particularly well suited to portfolio financing: Because of the unique pathological characteristics of these diseases, as well as the considerable support provided by the ODA, orphan drugs have higher success rates and shorter development times, but are still capable of generating lifetime revenues comparable to non-orphan drugs. In fact, a typical orphan drug can be expected to attain sales of $100 to $500 million per year, according to Thomson Reuters. Finally, the ODA provides a number of incentives to orphan drug developers including tax credits, expedited U.S. Food and Drug Administration review, and longer periods of patent protection. One analysis found that its impact extended the average combined patent/exclusivity period by nearly a year, resulting in an average competition-free marketing period of 11.7 years. MORE: What JPMorgan actually earned in 2013 An orphan disease mega-fund is not only a potentially attractive investment; it’s also a potential lifesaver. The drug development process has become expensive, lengthy, and risky — and not just for orphan diseases. The biotech and pharmaceutical sectors have performed miserably over the past decade, which has caused venture capital flows to wane. At the same time, government funding — another important source of funding for biomedical research — has been declining. In other words, this is an area desperate for funding, and a mega-fund would bring much-needed resources to drug discovery. The fund also has appeal to philanthropists and patient advocacy groups because they can put their dollars to work in a new way — by providing financial guarantees to mega-fund securities. The impact of such guarantees is to reduce the risk of the mega-fund, greatly expanding their appeal to a broader audience of potential investors, giving philanthropists just what want: impact. Finance doesn’t have to be a zero-sum game. With sufficient scale and proper financial engineering, you can actually do well by doing good. Andrew W. Lo is the Charles E. and Susan T. Harris Professor at the MIT Sloan School of Management and director of the MIT Laboratory for Financial Engineering.