Internet Index Funds: Should You Assume the Risk?

Three months ago, everyday investors would have been more apt to buy War bonds before touching an Internet stock.

But since the middle of April, some of these New Economy/e-commerce/money-losing stocks have made a nice comeback. And interested buyers will soon have three new ways to place that shaky bet.

Two recent columns discussed the new technology and small-cap index funds that have appeared. Today's column will look at Internet index funds and whether you should bother with them at all.

Within a matter of months, you'll have three Internet exchange-traded funds or ETFs to choose from. (ETFs are an emerging breed of mutual fund, which trade on stock exchanges and can be bought and sold every trading day just like stocks.)

The iShares Dow Jones U.S. Internet (IYV Quote) exchange-traded index fund from Barclays Global Investors recently hit the market. State Street Global Advisors is coming out with its own fund to track Morgan Stanley's Internet Index, called the MOX. Salomon Smith Barney also plans to launch an ETF to track its eponymous Internet index.

On the surface, all three of these indices seem very similar. Upon closer inspection, the Dow Jones index stands out as the best overall. The index is weighted by market capitalization, has a respectable cap on its top holdings and also has the clearest methodology.

Indexing the Internet
Index	Exchange-Traded Fund	Number of Stocks	Weighting Scheme	YTD Performance Through 6/19/2000
Dow Jones Internet	iShares Dow Jones U.S. Internet (IYV Quote)	40	Market-cap weighted with 10% ceiling	-27.9%
Morgan Stanley Internet	SSgA Morgan Stanley Internet*	28	Equal weighted	-28.3
Salomon Smith Barney Internet	SSBC Internet Index Shares*	30	Market-cap weighted with float adjustment and 20% ceiling	-23.9
Source: Dow Jones, Morgan Stanley, Salomon Smith Barney. *Coming later this year

First, take a gander at their year-to-date performance through June 19. They're all down more than 20%.

The number of holdings in each index comes pretty close. The Dow Jones Internet index has the most with 40 stocks. The Morgan Stanley and Salomon Smith Barney indices are neck and neck with 28 and 30 stocks, respectively.

In an extremely volatile area like the Internet, you want any index to rebalance with some frequency to make sure that a few of the stocks don't take over the index. All three of the indices rebalance every quarter.

"You need a good index to constantly adjust in a volatile, emerging sector," says Andrew Whittaker, a derivatives analyst at Lehman Brothers.

The Dow Jones and Salomon Smith Barney indices are both weighted according to market capitalization, meaning that the larger stocks have more control over the performance. In fact, the Salomon index adjusts for a company's float, or the number of shares available for trading by the public. This added step should ensure that the stocks in the index can actually be traded.

Most indices tracked by funds are market-cap weighted. Why? A market-cap weighting is based on liquidity. The larger companies have a bigger position than the small ones. If a fund wants to duplicate a market cap-weighted index, it won't have to buy a lot of the less liquid stocks.

The Morgan Stanley index is equal-weighted. To keep all the stocks at even weightings, you're buying the stocks that have done poorly and selling the ones that have done better. That structure could force a fund to trade more to stay in balance. It also creates a bias to smaller stocks because the index gives them equal footing with the bigger names.

In the Morgan Stanley index, all the stocks would have a weighting of about 3.57% when it is rebalanced. That approach would prevent a few stocks from taking over the portfolio.

But the Dow Jones index has a cap in place to avoid that same thing. The index carries a 10% cap for any one stock to keep the largest holding from completely dominating performance. The Salomon Smith Barney index also has a ceiling to limit the biggest stocks. But that index's cap is 20%, which could still result in a few stocks dominating the index.

The Salomon index's top three holdings -- America Online (AOL Quote), Yahoo! (YHOO Quote) and VeriSign (VRSN Quote) -- currently command more than 40% of the index's value. If you're going to buy an index with more than 30% or 35% of its value in just three stocks, you might as well just buy those three stocks. A large portion of the index's performance is going to come from those three names.

The Dow Jones index's top three holdings -- VeriSign, AOL and i2 Technologies (ITWO Quote) -- command about 24%. However, you should still get a good representation of the Internet sector with this index, as its aim is to capture 80% of the market capitalization of Internet stocks.

Most importantly, you want to make sure that any index's rules and parameters are absolutely clear. You want to know what it takes for a stock to make it into the index. Dow Jones is head and shoulders above Morgan Stanley and Salomon Smith Barney on this note. Its methodology is clearly stated on its Web site. Morgan and Salomon both offer information on their respective methodologies but the firms aren't nearly as revealing.

Frankly, none of these firms is exceptional at delivering up-to-date, easy-to-read information about their indices. But Dow Jones wins -- for now.

Of course, the Internet is still an incredibly unpredictable, combustible sector of the market. Some financial advisers will tell you that you're better off investing in an actively managed Internet fund, arguing that you need a manager to make investment decisions in such a rapidly changing business.

If you're truly afraid of losing any money, you may want to stay away altogether.

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