Partying Like It's 1999

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 , 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 (GOOG),  Amazon.com (AMZN), and  Priceline.com (PCLN), sit near all-time highs. Others have struggled of late, including  Twitter , which trades above its IPO prices, and small fries such as EarthLink Holdings .

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.

FDN’s top three holdings are Google (10% of assets), Amazon (7%), and Facebook (6.5%). All trade at rich valuations, and all are wide-moat firms. Google and Facebook are focusing heavily on the mobile parts of their businesses right now, as Google has enjoyed a meteoric rise in smartphone market share through its Android platform and Facebook has seen skyrocketing mobile usage with almost 1 billion mobile users. Both firms also are poised to be critical parts of the future of advertising, as Internet search advertising is still growing in the double digits and Facebook faces a need to open up its advertising platform.

Meanwhile, Amazon shares have been pressured after the company missed earnings by a meaningful amount in early 2014. In addition, some investors have become anxious over the expected (and recently announced) price increase for Amazon Prime, and some investors had what we consider to be overblown concerns about potential competition with Alibaba. There also was some general profit-taking and rotation out of the name by momentum investors. The company's announcement on April 2, 2014, of its Fire TV streaming media device is something that our equity analysts view as an intriguing customer acquisition tool that will capitalize on consumers' continued shift to digital media while promoting Prime memberships and cloud computing capabilities.

Portfolio Construction
This ETF tracks the market capitalization-weighted Dow Jones Internet Composite Index, which selects its components based on a combination of the three-month average float-adjusted market capitalization and the three-month average share volume. The index's goal is to capture 80% of the float-adjusted selection universe. Dow Jones requires index constituents to generate at least 50% of their revenue from the Internet.

Dow Jones reviews the index composition each quarter and rebalances the index quarterly. As a result, new constituents can be added from the selection universe four times a year. The index requires new IPOs to have a minimum of three months' trading history, although spin-offs only require that level of trading history if the parent stock has been trading for less than three months.

Names in the index range from heavyweights like Google and Amazon.com all the way down to more-obscure micro-cap and small-cap companies such as Ebix (EBIX), Vocus , and VirnetX Holding Corp. (VHC).

Fees
FDN's 0.57% expense ratio is a bit on the pricey side relative to other technology-themed ETFs. FDN's estimated holding cost is slightly higher, at 0.60%. Estimated holding costs are primarily composed of the expense ratio but also include transaction costs, sampling error, and share lending revenue.

Alternatives
Investors interested in ETFs that focus on Internet companies have several options, including PowerShares NASDAQ Internet Portfolio Holdings (PNQI) (0.60% expense ratio), which holds a market-cap-weighted basket of 99 Internet companies. PNQI is a much smaller fund, with less liquidity. Its $375 million in assets comprise a fraction of the more than $2.2 billion invested in FDN. In addition, FDN is far more liquid, trading some 5 times the number of shares each day that PNQI does.

And while both FDN and PNQI track market-cap-weighted indexes, there are some important differences between FDN and PNQI that investors should note. First, FDN is a more concentrated portfolio than PNQI, holding less than half the names that PNQI does. Next, the portfolio compositions are fairly different. PNQI's index includes a variety of foreign but U.S.-listed firms, while FDN's index sticks to U.S.-domiciled firms only. As a result, the PowerShares offering holds names such as  Baidu (BIDU), Qihoo 360 Technology , Yandex (YNDX),  NetEase (NTES), and  SINA . By contrast, FDN tracks an index consisting solely of U.S. companies. So, FDN's portfolio is 100% devoted to U.S. stocks, while some 15% of PNQI's assets are invested in overseas companies.

Another important distinction between the two funds relates to the kinds of companies that each index provider chooses to include. FDN's index's expansive definition of "Internet" allows it to include financial-services companies such as E*TRADE Financial and  TD Ameritrade , a health-care information solutions provider that is classified as a health-care firm ( Allscripts (MDRX)), and software maker  Salesforce.com (CRM). PNQI's index does not include any of these firms. However, PNQI's index defines the Internet to include some Internet content providers such as  AOL ,  CoStar Group (CSGP),  Pandora , and  Zillow (Z), none of which is found in FDN.

From an IPO standpoint, PNQI--like FDN--also tracks an index that requires newly listed companies to be seasoned with a minimum of three months' trading. As a result, a newly public firm doesn't end up joining PNQI's index until the next quarterly rebalancing and reconstitution of the index that occurs after the company's three-month anniversary of being public.

Over the past five years, PNQI has outperformed FDN, although that has been driven most by the fund's meaningful besting of FDN over the past 12 months (50.2% return versus FDN's 41%). Over the past half-decade, PNQI also has had slightly higher volatility (21.3% volatility of return over the past five years versus FDN's 19.8%).

Investors looking for broader exposure to the technology sector can consider  Technology Select Sector SPDR (XLK) (0.16% expense ratio) and  Vanguard Information Technology ETF (VGT) (0.14% expense ratio). FDN's performance is 87% and 89% correlated with these funds, respectively, over the past five years.

Data also show that over the past five years, the performance of FDN is 92% correlated with the performance of the Nasdaq Composite Index. This is an index that an investor can replicate by buying Fidelity Nasdaq Composite Index Tracking Stock Fund ETF (ONEQ)--for a 0.21% expense ratio.

 

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