First Trust DJ Internet Index: This internet stalwart ETF is finally a buy (NYSEARCA:FDN)

Tech stocks across the spectrum took a beating in 2022 as inflation and interest rates soared. However, new survey data reveals that most economists predict the Fed will indefinitely halt its rate-hike campaign after two additional 25 basis point hikes, leaving the fed funds rate slightly below its previously announced target of at least 5.25%. this along with contradictory economic data To suggest that any recession is likely to be mild as long as the Fed caves soon seems pretty bullish for stocks, particularly those that are highly sensitive to interest rate movements.

So today I’m going to take a look at a couple of my favorite beat-up tech ETFs, the First Trust Dow Jones Internet Fund (NYSEARCA:FDN) and the Global X Cloud Computing ETF (CLOU), to see if the time is right to initiate a position in one or both. This second article will focus on the much larger and more established ETF of the two, FDN.

General description

The First Trust Dow Jones Internet Index Fund is a 42-share ETF with an above-average annual expense rate of 0.51% and no dividends. From its inception in 2006 through the end of 2021, FDN served as a reliable replacement for (QQQ) with a more aggressive growth profile and lower yield, making it a strong core technology holding with tax advantages. Its significant exposure to the largest tech companies such as Alphabet (GOOGL), Amazon (AMZN) and Meta (META) has traditionally been seen as a source of resilience during market downturns, as its top 10 holdings (nine companies, as include both Google (GOOG) and (GOOGL) comprise almost 50% of the portfolio.

stock selection

FDN is compared to the Dow Jones Internet Composite Index, which selects the 40 largest companies listed on the NYSE or Nasdaq that derive at least 50% of their revenue from the Internet, a fairly broad and subjective requirement in today’s economy, for say the least!

Of these 40 stocks, 15 must be classified as Internet commerce companies, such as online retail, financial services, travel, and social media, and 25 must be classified as Internet service companies, such as cloud computing, website creation, and business software. Positions are then weighted by market capitalization and trading volume in descending order, with individual weightings capped at a maximum of 10%.

Given this methodology, it’s no surprise that mega-caps Alphabet, Amazon, and Meta hold the top three spots and more than 25% of the combined weighting. With such a large percentage of the FTN dedicated to three companies, I think it’s safe to say that if you don’t think GOOGL, AMZN, and META will rally as the market recovers, another ETF might be a better fit for your needs.

Risk

For sector ETFs, I strongly prefer passive index funds because they won’t trade in and out of positions due to the psychological motivations of fund managers or try to time the market by buying low and selling high, plus the annual rebalancings required by their benchmark methodology.

One of my main issues with ETFs like FDN, which use indices with such broad and subjective inclusion criteria, is that they can sometimes blur the line between passive and active fund management. While the Dow Internet Composite Index’s stock selection criteria sounds somewhat rigid and well-defined, there is clearly plenty of room for fund managers to decide which companies to include based on their interpretation of the phrase “50% of earnings from Internet“.

This is also why I tend to stay away from subsector ETFs, as the modern distinction between words like “technology,” “cloud,” and “internet” is pretty vague, and it could be argued that almost every aspect of major communications technologies and companies and their products is in some way connected to the Internet and its use. This may be obvious, but the bottom line for investors is that even index-based ETFs can have portfolios that fund managers select largely arbitrarily based on their own view of the market.

In terms of sector exposures, we note that FDN has large allocations to consumer-facing, technology-based communication stocks and low allocations to finance, healthcare and real estate. Looking at all of its holdings, it becomes clear that FDN’s overall portfolio is actually quite risky compared to QQQ, with most of its positions outside of the top ten resembling holdings in ARKK or high-risk tech funds and similar high-reward companies that focus exclusively on sales growth potential rather than profitability in areas like SaaS, e-commerce, and cybersecurity.

The inclusion of beaten names like Cloudflare (NET), Teladoc (TDOC), DocuSign (DOCU), Pinterest (PINS) that thrived during the COVID lockdowns but have since faded due to high valuations with no clear paths to profitability I’m a little worried. on FDN’s risk profile. However, since it is index-linked and not actively traded like ARK funds, investors can now benefit from its potential recovery as interest rates slowly rise and the market recovers from a brutal 2022.

Performance

Let’s take a look at FDN’s historical total return against QQQ since its inception in 2006:

While FDN has outperformed QQQ for most of its long tenure, FDN’s drawdown from late 2021 to late 2022 outpaced QQQ’s by a wide margin, pulled down by the same large-cap tech exposure that once served as a buoy Shares of AMZN, GOOG, and META all tumbled much more than the overall market last year, helping FDN underperform QQQ by 13%.

Conclution

I’m primarily a dividend growth investor focused on companies that offer rising income and growth at a reasonable price, so volatile pure growth ETFs like FDN don’t typically tempt me. But given that interest rate hikes are likely to slow and stall in the coming quarters after such a large, macro-driven drawdown in internet-centric stocks in 2022, I see relatively limited downside at current levels. for FDN, and I see maintaining a diversified technology. ETFs like this as a smart way to capture the upside of a gradual market recovery.

Investors should expect high volatility as these stocks rally, and I expect the broader market to break past its previous highs well before many of FDN’s holdings. Still, with so much valuation ground lost to catch up, a high percentage of large-cap tech holdings, and a long track record of outperforming QQQ, I rate FDN a Buy at current levels as a core diversified tech holding for investors. long-term.