Dear Dagen: How to Shop for a Net Index

E*Trade (EGRP) just opened an E-Commerce index fund based on the Goldman Sachs E-Commerce index. What's the history of new index funds designed to match new indices? What's their staying power and utility as benchmarks?

-- Tim Shultz

Tim,

Internet indices have one big problem: no history.

The rapid evolution and expansion of the Internet mean you'll find several immature but divergent indices that attempt to track this morphing industry.

A single, dominant Internet benchmark hasn't emerged. Instead, the existing Internet indices vary in size, shape and character. One might track 50 stocks; another might include only 20. Indices following subsectors of the Internet are already starting to appear.

Confusion.

Index of Net Indices
Index	Number of companies	Weighting scheme	Tracked by a mutual fund?
Dow Jones Composite Internet	40	Market-cap weighted with 10% ceiling	No
Inter@ctive Week Internet	50	Market-cap weighted with 25% ceiling, 50% ceiling for top five stocks	No
CBOE Internet	13	Equal weighted	No
TheStreet.com Internet Sector	20	Equal weighted	No
internet.com ISDEX	50	Market-cap weighted with 10% ceiling	(GFINX)Guinness Flight internet.com Index fund
Wired Magazine	40	Market-cap weighted with $10 billion ceiling	(GFWIX)Guinness Flight Wired Index fund
Goldman Sachs E-Commerce	39	Market-cap weighted with 7.5% ceiling	E*Trade E-Commerce index fund
Source: Lehman Brothers, Bloomberg.

However, you can look for certain characteristics in any Internet index to determine whether it's good, bad or merely mediocre.

When you invest in an Internet index, you'll want to be sure that a few years from now, that index will reflect the nature of your original investment and represent the same sector. An index's methodology for removing stocks and adding new ones should be specific and transparent.

Sure, indices have to change. "You have to make sure an index is built to address that," says Andrew Whittaker, a vice president of equity derivatives research at Lehman Brothers. "Over time, it should make changes in a concise way so the stocks that are in it at the end of two or three years will still represent the Internet space."

For example, a so-called revenue screen would prevent a company from staying in the index if its business shifts to non-Internet areas. A company might have to derive 50% of its revenue from genuine Internet activities to make it into an index or to stay there. For instance, the Goldman Sachs E-Commerce index requires companies to generate at least 80% of revenue online.

An index's rules and parameters should also be absolutely clear and readily available. Hopefully, you should be able to find this information on the compiler's Web site. This is an Internet index, after all.

You'll also want to make sure that the components in the index are liquid and actually trade.

If you are buying a fund that tracks an Internet index, you're probably better off picking an index that's market-capitalization-weighted rather than equal-weighted. (TheStreet.com Internet Sector index carries equal weightings in 20 stocks.)

A market-cap weighting is based on liquidity, giving larger companies a bigger position than smaller ones. If a fund wants to mimic a market-cap-weighted index, that fund won't be forced to buy a lot of some less-liquid stocks, says Whittaker. A market-cap-weighted index is easier to trade and transaction costs tend to be lower -- a paramount concern for an index-fund investor.

With market-cap-weighted indices, you might see a cap on allocations to any individual stock, meaning a single component cannot represent more than maybe 10% or 20% of the index. That limitation will prevent a few very large stocks -- like America Online (AOL) and Yahoo! (YHOO) -- from dominating the index's performance and increasing its volatility. That also allows portfolios that track the index to meet the diversification requirements of a mutual fund.

You also want an index that rebalances fairly often, which will also constrain any stocks that might tend to overtake the index. The majority of the Internet indices rebalance quarterly. The Wired Index from Wired magazine, which is really a new economy index, rebalances annually.

You'll also want an index with a good number of stocks. Ten stocks or fewer probably won't give you enough diversification. And "you don't want too many stocks that are too small. That will have substantial impact on increasing your transaction costs," says Whittaker.

You should also see whether derivatives, such as options, trade on a given index. That will give you more investment choices and could potentially boost the liquidity of the index. For example, options trade on TheStreet.com Internet Sector index and on the Inter@ctive Week index, among others.

Lastly, it all comes down what stocks you want to own. You may want a pure Internet play, which doesn't include peripheral companies like Lucent (LU) or Cisco (CSCO). Or maybe you want your index to include a broader array of big names.

As for actual Internet index funds, you only have a few to scrutinize. Investec Guinness Flight runs two: the (GFINX)Guinness Flight internet.com Index fund, which tracks the internet.com ISDEX index, and the (GFWIX)Guinness Flight Wired Index fund.

The internet.com Index fund is more of a true Internet play, tracking 50 stocks. The Wired index is meant to reflect the so-called new economy and includes some decidedly non-Internet names like oil services company Schlumberger (SLB). (Both Guinness funds carry expense ratios of 1.35% -- high for index funds -- and redemption fees if you sell shares within 30 days of buying them.)

The E*Trade E-Commerce index fund, which tracks the Goldman Sachs E-Comerce index, made its debut only a month ago. Save for the fund's prospectus, you won't find too much information on it. It doesn't even have a ticker symbol yet.

The expenses are 0.95%, and the fund carries a 1% redemption fee for shares sold within six months. To keep expenses low, shareholders have to agree to receive all information about the fund electronically

The underlying Goldman Sachs index isn't much older. It only launched in August. The modified market-cap-weighted index consists of 39 stocks, including Microsoft (MSFT) and Charles Schwab (SCH). To make the index, a company must generate the majority of its revenue online, operate as a virtual organization outside traditional real-world approaches or be a prominent e-commerce infrastructure provider.

Right now, Goldman doesn't provide details about this index on its Web site but plans to in the future.

Unfortunately, these Internet indices and Internet funds are so young you can't tell how they will behave in the future. But the above guidelines should at least help in your analysis as the field continues to grow.

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