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Partying Like It's 1999

We take a look at a large and liquid Internet ETF. Beware bubbles and monitor valuations.

Robert Goldsborough, 04/04/2014

Morningstar's Take
As United States equities continue to hit all-time highs, one of the dynamics capturing plenty of attention in recent weeks has been initial public offerings of high-tech companies and, in particular, Internet firms, such as "Candy Crush Saga" game maker King Digital Entertainment KING, which went public last week, and Chinese Internet colossus Alibaba Group, which is preparing to list in the U.S.

Meanwhile, for other large, already-public Internet companies, performance has been mostly positive. Some, such as Facebook FB (which has returned 147% over the past year), Google GOOGAmazon.com AMZN, and Priceline.com PCLN, sit near all-time highs. Others have struggled of late, including Twitter TWTR, which trades above its IPO prices, and small fries such as EarthLink Holdings ELNK.

We see nothing on the horizon to slow down continued growth in Internet companies. And for investors who anticipate continued strength and believe that there’s still upside from here, an exchange-traded fund is a convenient way to tap into growth in the sector--and future IPO activity--while limiting single-stock risk.

The largest and most liquid U.S. Internet ETF is First Trust Dow Jones Internet Index FDN, which offers investors exposure to a basket of 40 of the biggest and most influential publicly traded Internet companies. FDN is a fairly concentrated exchange-traded fund, with the top 10 holdings making up some 53% of assets. As such, we'd urge would-be investors with a strong conviction in the Internet space to treat this fund as a small satellite holding, to be implemented tactically as part of a diversified portfolio. Because of its narrow sector focus, this ETF lacks the diversification of broader funds. For example, over the past five years, it has had a volatility of return of 19.8% compared with 14.0% for the S&P 500.

The index that this ETF draws companies from requires firms to generate at least 50% of their annual revenue from the Internet. That means that a variety of high-tech names with significant lines of business in other areas of technology, such as Apple AAPL and Microsoft MSFT, are not held in this fund.

Despite FDN's niche focus and popularity, this fund's performance is strongly correlated to that of a broad technology ETF, Vanguard Information Technology ETF VGT, whose expense ratio is less than one fourth that of FDN.

Fundamental View
Although Internet-oriented companies like Google, Amazon.com, Facebook, and eBay are some of the world's best-known companies, they inhabit a space that up to now has not been easy for Wall Street to categorize. While most Internet companies are engaged either in Internet commerce or Internet services, Wall Street typically assigns Internet companies to the consumer services or consumer cyclical industries, others to the media industry, others to business services, and still others to specialty retail.

Most companies engaged in Internet commerce or Internet services have continued to grow nicely and benefit from powerful trends toward increased online ad spending, increased time spent online, and aggregation of consumer data.

Robert Goldsborough is an ETF Analyst at Morningstar.

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