The online business segment is growing by leaps and bounds. The Internet has afforded the Googles, Facebooks, Amazons of today limitless opportunities to conquer the virtual world. Without the bounds of a local presence and physical locations, Internet-based businesses continue to garner higher valuations with innovative offerings and expansion into global markets. (For more, see: How To Start An Online Business.) We look at the world of Internet business and at an ETF that offers a single means to invest in the largest U.S. Internet companies. (For more, see: The Industry Handbook: The Internet Industry.)

Internet Businesses

The Internet-based business sector is broadly divided into two categories: commerce companies and services companies. The former generate the majority of their revenues by providing goods and/or services through an online network, while the latter generate the majority of their revenues by providing access to the Internet and/or content, or by providing services to individuals or organizations using the Internet. Search engines (like Google and Yahoo!), online shopping portals (eBay and Amazon), hosting services (Rackspace), online media content providers (Netflix), and even online financial services (E*Trade) derive their business from the Internet.

Investing in Internet Businesses

Investors can buy stocks of such Internet companies and benefit from the high valuations. However, stock-specific risk continues to haunt such an investment. For example, consider the performance of a few major Internet-based businesses like Amazon.com Inc. (AMZN), Twitter Inc. (TWTR) and Rackspace Hosting Inc. (RAX) over the last three years, as displayed in the graph.AMZN-TWTR Performance

Source: Google Finance

An investor who opted for Amazon would have managed to double his money with +100% returns, while the unfortunate ones who selected Twitter or Rackspace would have been sitting at a loss of -35% and -50% respectively.

Picking the right stocks at the right time at the right price level remains a challenge for common investors. Additionally, picking multiple stocks also results in high transaction costs, as each specific trade costs money.

Mutual funds and exchange-traded funds (ETFs) offer a solution to the problem. They pool in money from thousands of investors and create a large capital corpus. It is then used to invest in multiple stocks based on a defined theme (like Internet company stocks). Experienced fund managers select stocks, backed by detailed research and analysis. In essence, an investor may simply purchase mutual fund units at end-of-the-day NAV price, and get the benefits of diversification, professional money management and low transaction costs. (For more, see: How A Mutual Fund Works.)

Exchange-traded funds offer the dual benefits of diversification of mutual funds and real-time tick-by-tick trading of a stock. ETFs usually follow a passive investment strategy, most common of which includes replicating the holdings of an index. (For more, see: An Introduction To Exchange-Traded Funds (ETFs) - Video.)

A fund or an ETF that invests in stocks of online businesses might offer the right fit. The First Trust Dow Jones Internet Index Fund (FDN) ETF is one such ETF that invests in U.S.-based Internet companies. Let’s explore the details of this ETF.

The FDN ETF tracks the underlying benchmark index called the Dow Jones Internet Composite Index (DJINET – see index factsheet). An index is a single number indicating the collective valuation of a selected basket of stocks. Positive or negative changes to the index are an indicator of how that particular basket of stocks is performing.

The DJINET index represents the basket of 40 largest and most actively traded stocks of the largest U.S.-based companies in the Internet industry. To qualify for inclusion in the index, a listed company must generate at least half of its business revenue from the Internet. Additionally, it should have a three-month average market cap of at least $100 million, and a three-month average closing price of at least $10. All these requirements ensure that only the most valuable companies in the Internet business make way to the index.

Index Constitution

All companies operating in the Internet commerce and services sectors and matching the above criteria are identified. The float-adjusted market capitalization value is calculated for each. Market capitalization (or simply market cap) is calculated as (number of total shares * current share price). Float adjusted indicates that only shares available to investors for trading in the open market are counted, leaving aside the shares held by governments, promoters or other companies. Float-adjusted market capitalization value thereby indicates the value of a company at any given point in time. The list is arranged in the descending order of the float-adjusted market cap values.

The constituents of the index are reviewed for any changes on quarterly basis in a rebalancing exercise. During such rebalancing, the companies no longer qualifying for the top 40 are knocked-off the index and replaced by new entrants. This rebalancing takes place on the third Friday of March, June, September and December. It ensures that the index adheres to the most recent “top-40” Internet companies in terms of valuations.

Inside the Index

Each constituent company is assigned a weight within the index. This is calculated by dividing the market cap of the individual constituent company by the sum of market caps of all 40 constituent companies (that is, the market cap of entire index). Sum of all constituent weights adds up to one or 100%.

Let’s understand the weight and its significance with a simple example. Assume there are 10 companies each with $10 million market cap, 20 companies each with $5 million market cap, and remaining 10 companies each have a $2 million market cap. The total market cap of all 40 companies will come to (10*$10 million + 20 *$5 million + 10 *$2 million) = $220 million. The top 10 companies (each having market cap of $10 million) will get an index weight of $10 million/$220 million = 4.545%, next 20 companies (each having market cap of $5 million) will get an index weight of $5 million/$220 million = 2.273%, and the last 10 companies (each having market cap of $2 million) will get an index weight of $2/$220 = 0.909%. The sum total of all index weight would add to one or 100% (= 10 companies * 4.545% + 20 * 2.273% + 10 * 0.909%).

This individual company weight indicates the extent to which change in price of a company stock can move the index value. If the market cap of a company (which has an index weight of 4.545%) increases by 10%, it will increase the index value by 0.4545% (= 4.545% * 10%). A similar change of 10% in market cap of a company having only 0.909% index weight will increase the index value by only 0.0909% (=0.909% * 10%).

In essence, the larger a company in terms of market cap, the more index weight it has, and the more influence it has on overall index value changes. To prevent one (or a few) heavyweight company severely impacting the index valuation, each company weight in the Dow Jones Internet Composite Index is capped at 10%. 

As the prices of all 40 constituent companies continuously change during trading sessions, the value of the index is calculated every three minutes during U.S. stock exchange trading hours. This assists in having the benchmark index values available for real-time comparison with the ETF valuation.

Historical Performance

DJINET Historical Performance

Following the peak of 500 during the dotcom boom around mid-2000, the dotcom bubble bust took the index to its lowest value of around 26 during October 2002. Since early 2009, this index has seen a regular and consistent increase indicating the growth of Internet businesses.

From Index to ETF

We've seen how the basket of top 40 U.S. Internet-based company stocks is configured in the index and how its value moves with changes in the prices of the constituent companies. In simple terms, the FDN ETF tries to replicate the performance of the underlying benchmark index mentioned above. It attempts to do so by investing a minimum of 90% of the capital into the stocks of the underlying index, in the same weight as that in the index. The remaining 10% (or less) capital is retained in cash or highly liquid money market instruments to facilitate the daily requests for creation/allocation of new shares or redemption.

This fund was started on June 19, 2006 with the starting NAV value of $20 and was trading at $67.35 in early September 2015. It has a low expense ratio of 0.54%, and has achieved a Morningstar rating of five-stars. Its comparative performance with the index indicates that it has managed to replicate the underlying index to a good extent.

DJINET-FDN-Performance

There is a minor deviation between the performance of FDN fund and the DJINET index, as visible in the gap between the red and blue graphs. This is due to the fact that entire 100% of fund capital is not invested in the index constituents, and there are transactional costs in fund operations absent in index. This constitutes the tracking error, which indicates the difference between the performance of a fund and its underlying benchmark index. (For more, see: How can I calculate the tracking error of an ETF or indexed mutual fund.)

Fund v/s Individual Constituent Stocks

The FDN ETF has scored well in tracking the underlying index. But how did it perform compared to the individual constituent stocks?

The recent top holdings of the ETF include Google Inc. (GOOGL), Facebook Inc. (FB), Amazon.com Inc. (AMZN), eBay Inc. (EBAY) The Priceline Group Inc. (PCLN) and Salesforce.com, Inc. (CRM). 

FDN Historical Performance

In last five years, the above comparative chart indicates that the FDN has achieved its intended objective of closely representing the mixed basket of the 40 top Internet stocks. It may not have performed as well as The Priceline Group Inc. or Amazon.com, but it did not perform as badly as Facebook Inc. during mid-2012 to mid-2013. It fits in between, which is indeed the objective of the fund.

The Bottom Line

The FDN fund offers a great way to diversify into Internet sector with one single investment. Though it has performed well, investors should not forget the risk factors. Investing in this fund is essentially making a bet on Internet-based businesses, which are highly correlated to each other. Most of the constituent stocks belong to small and mid-sized companies that are susceptible to price volatility, adverse impacts of economic changes, and limited liquidity. The technology sector has its own intrinsic risks, including rapidly changing technologies, short life cycles, intense competition and a concentration of U.S.-based companies. Internet-savvy investors can consider investing a limited portion of their portfolio into this fund.

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