First Trust DJ Internet Index: This Internet ETF Stalwart Is Finally A Buy (NYSEARCA:FDN)

Tech stocks across the spectrum took a beating in 2022 as inflation and interest rates soared. However, new polling data reveals that a majority of economists are predicting that the Fed will indefinitely pause 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 conflicting economic data suggesting that any recession will likely be mild as long as the Fed relents soon seems to be quite bullish for equities, particularly those that are highly sensitive to interest rate movements.

So today I’m taking a look at a couple of my favourite beaten-down tech ETFs, the First Trust Dow Jones Internet Fund (NYSEARCA:FDN) and the Global X Cloud Computing ETF (CLOU), to see whether it might be the right time to initiate a position in either or both. This second article will focus on the much larger and more well-established ETF of the two, FDN.

Overview

The First Trust Dow Jones Internet Index Fund is a 42-holding, top-heavy ETF with an above-average annual expense ratio of 0.51% and no dividend. From its inception in 2006 through late 2021, FDN served as a reliable substitute for (QQQ) with a more aggressive growth profile and a lower yield, making for a solid tax-advantaged core tech holding. Its significant exposure to the biggest tech companies like Alphabet (GOOGL), Amazon (AMZN), and Meta (META) has traditionally been viewed as a source of resiliency during market downturns, as its top 10 holdings (nine companies, since these include both Google (GOOG) and (GOOGL) comprise nearly 50% of the portfolio.

Stock Selection

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

Of these 40 stocks, 15 must be internet commerce companies like online retail, financial services, travel, and social media, and 25 must be classified as internet services companies such as cloud computing, website creation, and enterprise software. Positions are then weighted by market cap and trading volume in descending order, with individual weightings limited to a maximum of 10%.

Given this methodology, it’s not surprising that mega caps Alphabet, Amazon, and Meta take the top three spots and over 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 believe that GOOGL, AMZN, and META will rebound as the market recovers, another ETF might be better suited to your needs.

Risk

For sector ETFs, I strongly prefer passive index funds because they will not trade in and out of holdings due to the psychological motivations of the fund managers or attempt to time the market by buying low and selling high, aside from the annual rebalances mandated by their benchmark index’s methodology.

One of my main issues with ETFs like FDN that use indexes with such broad, subjective inclusion criteria is that they sometimes can 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 a lot of room for fund managers to decide which companies to include based on their interpretation of the phrase “50% of revenues from the internet“.

This is also the reason that I tend to stay away from subsector ETFs, as the modern distinction between words like “tech”, “cloud”, and “internet” is quite vague, and one could argue that nearly every aspect of major tech and communications companies and their products is in some way connected to the internet and its usage. This may be obvious, but the takeaway for investors is that even index-based ETFs can have portfolios that are largely selected arbitrarily by fund managers based on their own view of the market.

In terms of sector exposures, we see that FDN has large allocations to tech-based communication and consumer-facing stocks and low allocations to financials, health care, 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 the holdings in ARKK or similarly high risk, high reward tech funds that focus purely on sales growth potential instead of profitability in areas like SaaS, ecommerce, and cybersecurity.

The inclusion of beaten-down names like Cloudflare (NET), Teladoc (TDOC), DocuSign (DOCU), Pinterest (PINS) that thrived during COVID lockdowns but have fizzled since due to high valuations without clear paths to profitability make me a bit concerned about FDN’s risk profile. However, since it’s tied to an index and not actively traded like ARK’s funds, investors can now benefit from their potential rebound as interest rate hikes slow and the market recovers from a brutal 2022.

Performance

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

While FDN has outperformed QQQ for most of its long tenure, FDN’s drawdown from late 2021 through the end of 2022 exceeded that of QQQ 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 plunged far more than the overall market last year, contributing to FDN underperforming QQQ by 13%.

Conclusion

I’m mainly 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 normally tempt me. But with interest rate hikes likely to slow and pause in the next few quarters after such a large, macro-driven drawdown in internet-focused stocks in 2022, I see relatively limited downside at current levels for FDN, and I view holding a diversified tech ETF like this as a smart way to capture the upside of a gradual market recovery.

Investors should expect high volatility as these stocks recover, and I expect that the overall market will surpass its former highs far sooner than many of FDN’s holdings. Still, with so much lost valuation ground to regain, a high percentage of wide-moat, mega-cap tech holdings, and a long track record of outperformance against QQQ, I rate FDN a buy at current levels as a core diversified tech holding for long-term investors.