Play Internet Stocks With This ETF

This column was originally published on RealMoney on July 30 at 3:32 p.m. EDT. It's being republished as a bonus for TheStreet.com readers. For more information about subscribing to RealMoney, please click here.

About a year ago, I wrote about the then-new First Trust Dow Jones Internet Index Fund (FDN Quote). My general take was that FDN would be a good way to access the Internet group, while taking on much less volatility.

The actual Internet has turned out to be everything it was promoted to be, but you would probably get a mixed response about whether the stocks are living up to any expectations.

But Internet stocks can be easier for many people to understand than a lot of networking components or specialized semiconductors, because they use the Internet every day.

Since the Netscape IPO in 1995, Internet stocks have delivered a lot of feast and famine, but in the last few years have mellowed some. The stocks do still offer the potential for outperformance within the tech sector.

Clearly, the nature of these stocks is still that the wrong stock or a stock bought at the wrong time can be toxic to a portfolio. We need look no further than to Yahoo! (YHOO Quote) in the chart below for evidence of this.

The value of narrow ETFs such as this, assuming it has value (as some do not), is that they capture most of the effect of the sector, but with less volatility. While it has only been a short time, so far it seems that FDN has delivered. Using Google (GOOG Quote) as a proxy for Internet stocks, we see that FDN has had roughly the same return, but with fewer dramatic ups and downs.

Though the fund has had a successful start by this measure, it is worth exploring how it got here from there. When I first wrote about FDN, Amazon.com (AMZN Quote) was a large holding at 8% of the fund, but since then Amazon has gone up more than 100% and now has 12.5% weight.

Yahoo! was, and still is, a large holding. It is surprising that its 20%-plus decline has not been more of a drag on the fund, but one really bad performer should be offset in an up market.

Like the stocks that compose the Internet subsector, the valuations for FDN are not cheap, but they are a little better than when I first wrote about the fund. The price-to-earnings ratio now is 32.9 vs. 34 then, price-to-book is only 3.70, down from 7.99, and price-to-sales is now 3.79 compared with 6.55.

While I believe that FDN has been a reasonable proxy for Internet stocks, the fact is that since the fund came out, Internet stocks have lagged the broader tech sector as measured by iShares Dow Jones Technology Fund (IYW Quote).

This is probably attributable to the recent strength of mega-caps Microsoft (MSFT Quote), IBM (IBM Quote) and Cisco (CSCO Quote), which all weigh heavily in IYW. Typically, mega-caps do better later in the cycle than small-caps, and Google notwithstanding, FDN is a smaller-cap product with a median market cap of $1.6 billion.

In the first article, I opined that FDN would be more volatile than the rest of the sector, and while that might be true on the basis of the chart, I have to say that so far, it has not been as volatile as I might have thought. I think the reason might be that the lift in Google has been mostly offset by the decline in Yahoo! This doesn't seem likely to persist, and if it doesn't, then FDN would become more volatile.

I also previously felt that FDN would be a better holding than the Internet HOLDRs (HHH Quote), and while FDN has better returns, HHH still averages 330,000 shares per day, compared with only 28,000 for FDN. HHH is really a bet on eBay (EBAY Quote), Yahoo! and Amazon, which combine to make up 69% of the fund.

The biggest downside to this fund is that it will likely never capture the type of move that, for example, Amazon has had year to date -- up more than 100%. An investor who can successfully pick stocks in this group and can live with the consequence of the occasional downswings should probably stick to stocks, but anyone who is not comfortable with that sort of potential volatility will probably do well with FDN.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider First Trust Dow Jones Internet Index Fund to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.