The Frozen Yogurt of Net Sector Funds

"I know it's bad for me, but I gotta have it!" could apply to many things. For me, it describes a bowl of Starbucks Java Chip ice cream. For investors, it might be an investment product tied to an Internet index. But actually, the latter might not be so bad.

First Trust is getting in the sector ETF game with the First Trust Dow Jones Internet Index Fund ( FDN), which started trading Friday, June 30.

The fund has 40 components: 25 services companies and 15 commerce companies.

There are rigid rules for inclusion worth noting. A company must generate 50% of its revenue from the Internet, have been public for at least three months and have a market cap of at least $100 million. The constituents can change over time. The specific objective of the index is to capture 80% of the market capitalization of the Internet sector. That makes it possible for there to be more or fewer stocks in the index and by extension, the fund.

Google ( GOOG) is the largest holding in the fund at 11.2%, closely followed by Yahoo! ( YHOO) at 10.75%. Usual suspects eBay ( EBAY) and Amazon ( AMZN) are also well represented at more than 8%.

A couple of not-so-usual suspects are online brokerages E*Trade ( ET) and TD Ameritrade ( AMTD) at 8.4% and 4.38%, respectively.

Some of the numbers for the fund's holdings include an average price-to-earnings ratio of 34, an average price-to-book ratio of 7.99, an average price-to-sales ratio of 6.55 and a median market cap of $1.2 billion.

A chart of the underlying index compared with various other benchmark indices shows that it doesn't really correlate very closely to any of them. From that we can extrapolate that the fund will not serve as a proxy for anything else.

As the chart below shows, the DJ Internet Index has been much more volatile than the tech sector at large, represented by the Amex Computer Technology Index (XCI).

More Volatile Than Tech
The DJ 'Net Index has often diverged from the larger sector
Click here for larger image.
Source: BigCharts.com

Certain parts of the market are thought to offer the chance for big returns, and Internet stocks certainly do have that potential. But the chart and our memories tell us what a wild ride these stocks can offer.

For a little perspective, Internet stocks comprise less than 10% of the iShares DJ Technology Index fund ( IYW), and technology makes up 15% of the S&P 500. This implies that an equal weight for Internet stocks for a diversified portfolio is only 1.5%. While the merit of 1.5% is certainly open to debate, a 10% weight in the Internet at the wrong time will definitely hurt overall returns.

The role a fund like Dow Jones Internet Index fund can play in a portfolio is a speculative one. It offers the chance for market-beating returns and is a way to add volatility at points in the stock market cycle when that is desired.

Further, I believe FDN is a much better way to access the group than the Internet HOLDRs ( HHH). Because of its unusual methodology, eBay and Yahoo! account for 60% of the Internet HOLDRs. It is so lopsided that I'm shocked it sports any volume at all.

If you have sworn off the Internet for your portfolio, you may want to think again. Part of the hype during the Net bubble days was that the Internet would change our lives. Well, it certainly has, but it also has changed -- and matured.

It makes sense to believe that at some point, the stocks of Net companies could be important and fundamentally sound. First Trust Dow Jones Internet Index fund offers a reasonable way to access that belief while avoiding single-stock risk.


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.

At the time of publication, Nusbaum was long Yahoo! and iShares DJ Tech Index Fund for client accounts, 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; click here to send him an email.

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