Skip to main content

It's Getting Harder to Beat the Benchmarks Without Net Stocks

Managers of conservative funds look for ways to justify buying into the hot sector.

As Internet stocks creep into the indices used to size up mutual- fund performance, diversified fund managers are having to take a long, hard look at stocks they might otherwise consider too volatile and high-priced.

America Online


joined the

S&P 500

Dec. 31. The stock is also in the

Russell 1000

. So are




(AMZN) - Get Free Report

. Both are in the

Nasdaq 100

as well. And the

Russell 2000

is littered with Internet stocks. When the small-cap index is reconstituted next summer, as it is annually, many more Net stocks are expected to be included -- the result of a slew of initial public offerings late last year.

Fund managers wishing to dodge the complexity of picking Internet stocks now risk falling short of their respective benchmarks if the hot sector continues to trounce the overall market.

Once found primarily in technology funds, Internet stocks now may be an expensive nuisance that diversified fund managers can't afford to neglect.

"In a balanced fund you wouldn't expect to see Internet companies," says John Jares, co-manager of the $70 million


Berger Balanced fund. "But I think you have to stand back and think really, really hard, 'Is this business going to represent a secular change?' instead of just saying 'Valuations are real high and I'm not going to touch any Net stock.' "

Jares has been dabbling in Net stocks since he first bought AOL in 1996 while still a portfolio manager at

Founders Funds

. At the time, the Internet firm was losing money. "More than 40% of the Internet's traffic originated from AOL," says Jares of his early interest in the money-losing venture. "It was obvious they were going to win the war."

Now at Berger Balanced, Jares says he's scouring Internet companies to find firms he believes will enhance the value of his diversified portfolio. And despite his relatively conservative fund's charter, he's not letting traditional valuation measures deter him from companies he likes. "One thing I learned: If you were really hung up on valuation, you never would have bought AOL at any point," he says.

"I've stepped up my Internet play," says Jares. "I'm going to buy some, but leave myself room to average down if the price falls."

Jares says he'll position a maximum of about 4% of the fund's assets in the sector. He recently took a small position in

Ticketmaster Online-CitySearch


-- less than 1% of the portfolio. "They had a great quarter and I like the story. It's a real business in my mind," he says.


State Street Research

, Jim Weiss, deputy head of equities, says he's also struggling with ways to include Internet stocks among the $53 billion in assets his firm manages.

"It's a little easier to ignore these when they are not in your benchmark," he says. "The Internet stocks have been an important engine of performance that you hate to leave at the gate."

"I suspect diversified fund managers are trying to figure out ways to get these into the portfolio as opposed to using valuations as an excuse to ignore the area," says Weiss.

Weiss' firm is establishing Internet positions in its diversified mutual funds and in its institutional accounts. "Our research has uncovered a couple of names we think are well worth owning," he says. "It's simply a matter of answering the question: At what price?"

The manager declined to identify which stocks he's buying. But at the end of December, AOL was already a top position in two of the firm's growth funds: 5.5% of the $242 million

(STSGX) - Get Free Report

Growth fund and 2.8% of the $1 billion


Capital fund. It even showed up among the top holdings in the $717.4 million


Managed Assets portfolio -- a diversified growth-and-income fund.

To find a viable Net stock, Weiss first asks: Does the company have an enduring business model? And can it manage the risk of leapfrogging technology and a low barrier to entry?

If the answer to both questions is "yes," the stock picker waits for an opportunity to buy on the dip -- always keeping his price targets in perspective. "You cannot look at these in a traditional valuation model," says Weiss. "No model is going to tell you to pay 250 to 300 times earnings," he says. "Trouble is, if you wait until the earnings streams are solid and predicable, two thirds of the move is over."

Turner Investment Partners

, which manages $3.3 billion in mutual funds and institutional accounts, uses the

Russell 1000 Growth

, the

Russell Midcap Growth

and the Russell 2000 indices as benchmarks for its diversified mutual funds. Turner fund managers approximate the sector weightings of their respective benchmarks. As more Net stocks show up in these indices, they also are showing up in TIP funds.

AOL,, Yahoo!,


(ATHM) - Get Free Report

, Ticketmaster Online-CitySearch and



are just some of the Internet stocks held by the diversified growth-fund managers.

The bottom-up stock pickers say they aren't worried about paying too much for the stocks they like. "My experience with technology over the years is that the momentum in revenues and earnings overwhelms valuation," says Bob Turner, chief investment officer at Turner Investment Partners. "We are watching the growth of subscriber, e-commerce and advertising revenues," he notes. "Valuation comes into play when you see a slowdown."

Dan Cantor is one diversified fund manager who hasn't made any direct bets on the Internet. "It's not a denial of the importance of the Internet," says the

Stein Roe


Growth & Income fund manager. "It just reflects our style of investing, which is more on the conservative side."

For now, Cantor says he's content to own companies whose existing businesses are enhanced by the burgeoning industry. One example he offers is cosmetics manufacturer


(AVP) - Get Free Report

, which makes up about 1% of the $420 million fund. "If Avon makes a big business out of selling cosmetics on its Web site, the fund benefits indirectly from the Net," says Cantor.

The fund also has a 2.8% bet on



and a 2.1% position in


(IBM) - Get Free Report

-- two other "indirect" Internet plays Cantor likes.

As originally published this story contained an error. Please see Corrections and Clarifications.