IYW iShares US Technology ETF

By John Prestbo

A DOW JONES COLUMN

Facebook's pricey limited private stock sale to Goldman Sachs last month -- plus whispers of a $1 billion share tender by Facebook employees -- caught much of the market by surprise. In fact, it downright shocked many investors, turning their attention back to where it hasn't been for a decade: the Internet.

"Promising" is the word some use in describing the Internet's investment opportunities. What people probably have in mind is the expected initial public offerings of Facebook, LinkedIn and Twitter. Whenever these immensely popular online services "go public" -- speculation ranges from later this year to 2012 -- they could buoy the sector, and probably the entire stock market, at least for a while.

In fact, just the rumors about the values of these still-private companies are helping lift technology stocks overall. The Dow Jones U.S. Technology Index, which underlies the iShares DJ Technology ETF (IYW), is up 7.8% for the year ended Feb. 11, on a total return (dividends included) basis, compared to 6% for the entire stock market. Some market commentators already are warning about another bubble developing.

There's also an indexed investing play on the Internet, as opposed to stock-picking. In the late 1990s a multitude of Internet indexes sprung up. But most of them folded during the market's dot-com hangover.

Now, just a handful remain. TheStreet.com has an Internet index, as does USA Today, but only the Dow Jones Internet Index has a couple of products based on it. First Trust Dow Jones Internet Index Fund (FDN), which is exchange-traded, has about $640 million in assets. The leveraged Internet Ultra Sector ProFund (INPIX), which aims to return 150% of the index's performance on a daily basis, has assets of about $33 million.

 
   Web Of Choices 
 

Several mutual funds specialize in the Internet, but they are actively managed. The many exchange-traded and mutual funds focusing on the technology sector include many of the same stocks, but they are not "pure plays" on the Internet.

The Dow Jones Internet Index was launched June 30, 1997. It has 40 stocks, divided into two sub-groups: 25 Internet services stocks (companies whose technologies help make the Internet function) and 15 Internet commerce stocks (companies that sell stuff online). For its stock to be included, a company must have a market capitalization of $100 million or more and derive at least half of its annual revenue from direct Internet activity.

The revenue requirement keeps out some stocks that at first glance might seem like shoo-ins. McAfee Inc. (MFE) and Symantec Corp. (SYMC), for example, make software that among other things protects computers against software viruses and other malicious code that are transmitted over the Internet. But their product distribution largely goes through computer makers and retailers rather than online, so they don't qualify.

The 50% revenue rule also has made the stock-selection pool for the index pretty shallow at times, particularly when many qualified companies were bought up by larger outfits or went bust. Since inception, 104 index stocks have had to be replaced. That is an average of eight a year, but in bubble-popping 2000 there were 19.

Though the number of index components is tilted sharply toward Internet services, the lion's share of market cap is in Internet commerce. The 25 service stocks -- among them Akamai Technologies, Inc. (AKAM), CheckPoint Software Technologies Ltd. (CHKP) and Juniper Networks Inc. (JNPR) -- add up to $17 billion of market value.

The market value of the 15 commerce stocks -- including Amazon.com Inc. (AMZN), eBay Inc. (EBAY) and Google Inc. (GOOG) -- totals $21.6 billion. It would be much higher, but no stock can account for more than 10% of the index's weight. Currently, only two stocks are uncapped, and only Google reaches the 10% ceiling. Google is so big that it would dominate the index if it weren't restricted. The rule forces diversification, albeit within a concentrated sector.

 
   Below The Peak 
 

Even on a total return basis, the Dow Jones Internet Index basically tracks capital appreciation. Of the 40 stocks, 36 don't pay any dividends. The remaining four dispense relatively small ones. The largest cash payout is 16 cents a quarter from EarthLink Inc. (ELNK) . As of Jan. 31, the dividend yield of the composite index was just 0.15%.

So, how is the index doing in terms of capital appreciation? The good news is that it is a healthy 263.6% higher than where it started in 1997. The bad news is that it is still a full 70% below its peak in March 2000.

Internet commerce stocks set the performance pace in the index, and have done so since its beginning. They peaked earlier (spring 1999) and higher (up 1,459% from index inception) than the Internet services stocks (which jumped 1,329% to a high in the winter of 2000).

Moreover, commerce fell less (88%) than services (98%) when market sobriety set in. And the pattern has held up to the present. Since the end of 2002, the commerce stocks have jumped a cumulative 419% to 303% for the services stocks. On an annualized basis, that is 22.6% versus 18.8%.

As the performance suggests, volatility is a distinguishing characteristic of the Dow Jones Internet Index. Taken over its entire life span through Jan. 31 of this year, the index's returns deviated from average by almost 48%. But if the bubble-and-bust period is taken out, volatility falls to the mid-20% range. That is about the same as commercial real estate (as measured by the Dow Jones U.S. REIT Total Stock Market Index).

Investing in the effervescent Internet is risky, and clearly not for everyone. Even enthusiasts should limit the group to a small part of their overall portfolio. But if so inclined, the indexed investor can take a low-cost, diversified approach to a sector that is starting to realize the influence and profitability that was prematurely envisioned more than a decade ago.

(John Prestbo is editor and executive director of Dow Jones Indexes, a joint venture of CME Group Inc. and Dow Jones & Co., publisher of MarketWatch and this Newswire. He can be reached at 415-439-6400 or by email at AskNewswires@dowjones.com.)