ETFs Suffer With Their Sectors

The Internet HOLDRs ETF is poorly diversified, but that's not the only cause of its underperformance.
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A reader recently lamented to me the lack of what he called a good Internet ETF.

He made a comment about the

Internet HOLDRs

(HHH)

, which you can read more about in

Gregg Greenberg's column from the other day.

The key issues with Internet ETFs, as Gregg points out relative to HHH, are that they are woefully undiversified.

HHH relies on the success of

eBay

(EBAY) - Get Report

and

Yahoo!

(YHOO)

, as the two combine for over 60% of the fund.

The HOLDRs family has two other Internet-related products: the

Internet Architecture HOLDRs

(IAH)

and the

Internet Infrastructure HOLDRs

(IIH)

.

The architecture HOLDR is heavy in

IBM

(IBM) - Get Report

,

Hewlett-Packard

(HPQ) - Get Report

and

Dell

(DELL) - Get Report

, at 28%, 19% and 15%, respectively.

It is no surprise that the fund correlates to the

iShares Dow Jones Technology Fund

(IYW) - Get Report

, though it has lagged more of late because of the recent decline in Dell.

IIH is a graveyard for great ideas gone bust. Only seven stocks, out of the original 20, have a weight in the fund of greater that 1%.

So for now, the ETF universe may not be a great place to capture Internet stocks. There are open-end funds from at least six different fund families including

Jacob Internet

(JAMFX),

Kinetics Internet

(WWWFX) and

ProFunds Ultra Internet

(INPIX).

The open-ended funds have clearly outperformed HHH recently, because of better diversification. Perhaps an open-ended fund is the way to go for the investor who chooses not to take single-stock risk in this part of the market?

Similar Architecture
This HOLDR closely tracks the iShares tech fund

How the Tech ETFs Stack Up
Open-end tech funds vs. the HHH

The Rest of the Story

The topic, thus far, overlooks an important point which is that for the time being, this is the wrong part of the market.

The right parts of the market have been energy and emerging markets, and the ETFs and other products that capture these segments are no less flawed. But the components in these areas are all (intentional hyperbole) going up, and all the Internet stocks (another intentional hyperbole) are all going down.

If the components of HHH were all on fire, the flaws of the product would get less attention. For instance, when was the last time someone criticized the

Energy Sector SPDR

(XLE) - Get Report

for having 16% in

Exxon Mobil

(XOM) - Get Report

?

The flaws inherent in HHH will matter less, psychologically, the next time Internet stocks provide leadership to the market. The reader's comment that sparked this conversation is more about patience.

In a diversified portfolio some holdings should be out of favor, such as Internet stocks or mega-caps. If everything you own is in favor, then chances are you are not diversified. I realize that not everyone wants to have a diversified portfolio, but if you do want diversification, this is an important concept.

In the late 1990s, small-cap was given up for dead, and now it may be starting its seventh year of beating large-cap. Also in the late 1990s, value lagged growth badly, but in this decade value has outperformed growth by a wide margin. To the reader's point, at some point everything rotates back into favor, and this often happens when no one expects it to.

At some point the Internet subsector will rotate into favor, and if you are not sure that you can pick when that will be, it probably makes sense to maintain some exposure. But for all the reasons Gregg cited, I would not choose HHH.

At the time of publication, Nusbaum was long IYW and YHOO, although positions may change at any time.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, Ariz., and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback;

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