Five Ways to Trade the Internet Sector with ETFs

12/22/2010 12:01 am EST

Focus: ETFS

By Michael Johnston of

Investing in the Internet is fashionable again, and it's easier than ever to do so with sector ETFs.

In the early days of the ETF industry, most of the products were broad-based equity funds that offered exposure to domestic and international stock markets. But as ETFs have gained market share and become more popular with both buy-and-holders and more active traders, products have become increasingly specialized. Since the debut of the sector SPDRs in 1998, dozens of ETFs targeting various corners of the US and global equity markets have been introduced. Recent innovations have included small cap sector ETFs and sector-specific emerging market funds.

Additions to the ETF product lineup have also been increasingly granular, going beyond the nine traditional sector allocations (ten if telecom is included) to focus on sub-industries; there are multiple ETFs offering exposure to homebuilders, biotech firms, and makers of semiconductors, just to name a few.

Sector ETFs can be handy for investors who believe that certain corners of the market are overvalued or undervalued relative to the broad market. Generally, many of the underlying companies will be competitors impacted by the same macroeconomic factors. But that isn't necessarily the case for some of the best-performing equity ETFs of 2010; a handful of ETFs offering exposure to Internet-related companies have delivered big gains this year.

Focusing on companies that do business online is an interesting investment thesis; more and more Americans are turning the Web as a source for everything from videos to groceries, and the growth potential in untapped emerging markets is huge. Unlike most sector-specific ETFs, the Internet funds profiled below consist of stocks that are often engaged in very different businesses.

While the underlying companies are all built around the Internet, the products or services they offer are all over the board. As such, the economic factors that drive performance may be very different. Google's product (advertising impressions) differs significantly from that of Netflix (which rents DVDs), and neither of those companies is really comparable to PetMed Express or Shutterfly. So while Internet ETFs are in one sense very targeted, in another they are incredibly broad-based.

For investors looking to establish exposure to companies with a big online presence, here are five different ETF options:

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First Trust Dow Jones Internet Index Fund (FDN)

In order to be eligible for inclusion in the index underlying this ETF, a company must generate at least 50% of its revenue from the Internet (among other criteria). As a result of this rather broad qualification, FDN consists of an interesting group of stocks. Not surprisingly, the tech sector is well represented, but this ETF also maintains allocations to the consumer discretionary, financial, and health care sectors. FDN allocates about 10% of its holdings to Google, with Amazon, eBay, and Yahoo! also among the largest individual holdings.

PowerShares Nasdaq Internet Portfolio (PNQI)

This ETF seeks to replicate the Nasdaq Internet Index, a benchmark that consists of the largest US-listed companies engaged in Internet-related businesses. Again, while a common thread exists between underlying stocks, the components of this fund are involved in very different businesses. In addition to online marketplaces (, eBay) and search engines (Google, Yahoo!, Baidu), PNQI's exposure includes companies like Netflix, Akamai Technologies, Shutterfly, and PetMed Express.

HOLDRS Internet (HHH)

Another popular option for gaining exposure to the Internet sector is HHH, one of the HOLDRS products from Merrill Lynch. HOLDRS (holding company depository receipts) are often lumped under the ETF umbrella, but they are very different from traditional exchange traded funds in a number of ways. Because there is no underlying index and holdings aren't rebalanced, many HOLDRs have become concentrated in a handful of securities over the years. That's certainly the case with HHH, which allocates about 40% of assets to and holds only 13 stocks in total. And because new names aren't added to the basket, there are some interesting exclusions. HHH has no exposure to Google, for example.

HOLDRS Internet Architecture (IAH)

This HOLDRS product maintains a more targeted focus than the options profiled above; according to the prospectus, the goal is to provide exposure to companies that "develop and market computer hardware, Internet hardware and other related products designed to enhance the speed and efficiency of connections within and to the Internet, connections within a company's internal networks and end user access to networks." As such, many of the underlying holdings of IAH don't generate revenue directly from the Internet. IBM, Apple, HP, and Cisco are the biggest holdings, with about 80% of assets going to these four stocks.

HOLDRS Internet Infrastructure (IIH)

This fund is another unique twist on investing in the Internet. IIH consists of companies that provide software and services to allow Internet companies to better manage their Web sites and improve online communications. IIH doesn't offer much in the way of diversification-VeriSign accounts for about half of total assets and Akamai Technologies makes up another 30%

By Michael Johnston of

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