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Internet Index Funds Are Stretching the Concept of Indexing HOLDRs offer another passive way to invest in Net stocks Kathleen Pender |
Wednesday, April 26, 2000
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When people think of index funds, they think of words like cheap, predictable and straightforward. Internet index funds are anything but. In the past nine months, at least six mutual funds replicating four different Internet indexes have begun clamoring for investors' money. These funds resemble index funds as much as I resemble Catherine Zeta-Jones. Index funds replicate a stock index, usually a well-known one like the Standard & Poor's 500. They are ``passively'' managed, which means the managers don't predict where the market or individual stocks are headed. Instead, they buy the same stocks in the index, in the same proportions they exist in the index. Because the funds are cheap to operate, the expenses charged to shareholders are low, typically less than 0.5 percent per year. At least that's how they usually work. The Internet index funds differ in many respects: -- They are based on relatively new and obscure indexes that aren't always well defined -- or easy to find. The de Leon Internet 100 fund is based on the de Leon Internet 100 index, developed by fund manager Paul de Leon. Right now, de Leon is the only person following the de Leon index, which is not published anywhere. -- The fund managers don't always hew closely to the index. De Leon can actively manage 20 percent of the fund's assets. That's partly so he can put initial public offerings into the fund before he puts them in his 100-stock index. And although the fund is market-cap weighted -- meaning it owns stocks in the same percentage in which they appear in the index -- no single stock can represent more than 4 percent of the portfolio. As a result, America Online represents 17 percent of the de Leon index, but only 4 percent of the de Leon fund. Another fund that follows a ``modified market cap'' strategy is Guinness Flight Internet.com, which limits any single stock to an amount no more than 10 percent of fund assets. -- As if Internet stocks weren't dicey enough, some funds take on additional risk. The Potomac Internet Plus fund borrows money so that returns are 25 percent greater -- on the upside and the downside -- than the Dow Jones Internet index, which it replicates. That use of leverage helped the fund last year, when Net stocks were soaring, but has made it one of the worst-performing funds this year, with a 50 percent decline. -- The funds aren't always simple or straightforward. A companion to the Potomac Internet Plus fund is the Potomac Internet Short fund. This fund attempts to give a return exactly opposite the Dow Jones Internet index, says manager Dan O'Neill. But you cannot short that index or many of the stocks it contains. So the fund shorts derivative securities, such as HOLDRs, which are exchange-traded baskets of Internet stocks packaged by Merrill Lynch. (More on HOLDRs below.) This fund is so complex -- and potentially dangerous -- that the Potomac group doesn't actively market it. -- The funds are not cheap. The average expense ratio is 1 to 1.5 percent. That's in line with actively managed funds, but high for index funds. The fund managers say their expenses are high because the funds are so small -- Guinness Flight is the largest, with about $45 million in assets -- and that expenses will fall as the funds grow. But Christopher Traulsen, who follows Internet funds for Morningstar, doesn't buy it. ``They're charging far too much for what they do,'' he says. The biggest issue for investors is whether an index fund with a passive investment strategy is the right way to play an industry as dynamic and fast-changing as the Internet. Traulsen thinks it's not. ``You want a portfolio with some flexibility to get you out of things that are going to get cut in half,'' he says. That's why de Leon says his index fund is ``more fluid than some others.'' But other index fund managers say that the Internet's unpredictable nature is what makes it perfect for indexing. ``All the hype about the Internet doesn't come close to describing what we're going to go through over the next 10 or 20 years,'' says Jim Atkinson, managing director of Investec Guinness Flight. ``We know the industry's going to be terribly successful, but the technological changes are so rapid, it's difficult to predict who's going to be the big winner. With an index fund, you're buying the industry.''
INTERNET HOLDRS: Another way to invest passively in Internet stocks is with the aforementioned Merrill Lynch HOLDRs. Like closed-end funds, these are fixed baskets of securities that trade like stocks on the American Stock Exchange. Unlike closed- end funds, which often trade at a premium or discount to the underlying value of the stocks, HOLDRs are designed to trade at exactly net asset value. Shareholders can buy and sell HOLDRs just like stocks through a broker. For a small fee, they can also turn in HOLDRs at any time and get their portion of the underlying stocks. They can continue to hold these stocks or sell them in bits and pieces. This lets them control their taxes because they decide when to realize capital gains. With regular mutual funds, the managers decide when to sell stocks, and fund shareholders are often socked with capital gains taxes. Each HOLDR contains 20 stocks in a particular sector, such as broadband or telecom. Unlike the Internet index funds discussed above, HOLDRs are never ``rebalanced'' to keep up with changes in a stock index. If one of the companies in the HOLDR is acquired, the HOLDR will be down to 19 companies. HOLDRs are cheaper than mutual funds. Management fees are less than 0.10 percent annually and are paid out of dividends. If dividends don't cover the fees, they are waived. Stephen Johnson, a Palo Alto financial planner, recommends HOLDRs for clients who want exposure to the Internet but want to avoid the risk of owning individual stocks. ``They're tax-efficient. And they give us the opportunity to exploit intraday trading opportunities,'' he says. The original Internet HOLDRs (HHH) are up 21 percent since they premiered in September. Telecom HOLDRs (TTH), launched February 1, are down about 1 percent. Three other HOLDRs launched in late February aren't doing as well: B2B Internet HOLDRs (BHH) are down 59 percent, Internet Infrastructure HOLDRs (IIH) are down 48 percent and Internet Architecture HOLDRs (IAH) have lost 1 percent. Broadband HOLDRs (BDH) are off 13.5 percent since they were launched April 6. Other HOLDRs include Pharmaceutical (PPH) and Biotech (BBH). More are on the way.
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