Internet giants have dominated the market over the past decade and generously rewarded their shareholders. The industry was recently boosted by the COVID-19 pandemic when the world went into lockdown, and the global population relied on the internet more than ever. However, I think we are at a turning point for internet stocks. Recent economic data in the United States points to a strong labor market coupled with above-average inflation, which should prompt the Fed to raise interest rates and initiate quantitative tightening. That said, the United States is not the only region of the world where inflation is at its peak. This week, the BoE raised its key rate to 0.5% and the ECB turned hawkish amid higher-than-expected inflation. The reason economic data is important is that it has a direct impact on the stock market. Stocks, which are considered long-lived assets, will soon be discounted at a higher rate. As a result, there is a clear risk that valuations will suffer. In particular, I expect high P/E stocks to suffer the most going forward. In my opinion, internet companies are highly valued right now, which exposes investors holding these stocks to higher downside risk compared to the broader market. In this article, I will review the Invesco NASDAQ Internet ETF (NYSEARCA: PNQI)which provides exposure to a basket of companies engaged in Internet-related activities.
The Invesco NASDAQ Internet ETF tracks the performance of the Nasdaq CTA Internet Index. The index is designed to track the performance of companies engaged in Internet-related activities that are listed in the United States. These companies are involved in Internet software, Internet search engines, web hosting, website design, or Internet retail as determined by the Consumer Technology Association (CTA).
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Composition of the portfolio
From the sector allocation table below, we can see that the index places a high weighting on the communication services sector (representing around 39% of the index), followed by information technology (representing 29% of the index) and consumer discretionary (representing around 26%). The three main sectors have a combined allocation of around 94%. As the strategy suggests, this portfolio has a high allocation to technology. In my opinion, it’s important to see how this aligns with your diversification goals and whether you’re comfortable with a higher allocation to technology, which in turn can increase your portfolio’s volatility.
The top ten countries represent approximately 100% of the portfolio in terms of geographic allocation. The United States represents 79.19%, while other countries such as India seem to be under-represented given their low weight (only 0.07% allocation to India).
PNQI invests more than 63% of the funds in large-cap growth stocks, characterized as large companies where growth characteristics predominate. Large-cap issuers are generally defined as companies with a market capitalization greater than $8 billion. The second largest allocation is for large cap mixed stocks. Interestingly, this ETF allocates less than 20% of funds to mid- and small-cap stocks, which generally tend to outperform large-cap issuers over a long period of time.
The fund is currently invested in 81 different stocks. The top ten holdings represent 60.49% of the portfolio, with no stock weighing more than 10%.
Since these are stocks, an important characteristic is the valuation of the portfolio. According to Invesco, the fund is currently trading at an average price-to-book ratio of 7.26 and an average forward price-to-earnings ratio of 41.05. In addition, the portfolio has a return on equity of 13.18%. I generally consider a company that trades at a P/E ratio above 20-25 to be richly valued. Additionally, I think we are at a market inflection point where the Fed is ready to raise interest rates and begin quantitative tightening, which will put further pressure on valuations.
Is this ETF right for me?
I have compared the price performance of PNQI against the performance of the ETF Invesco QQQ below. (NYSEARCA: QQQ) which tracks the Nasdaq 100 over 5 years to assess which was a better investment. During this period, the NASDAQ 100 outperformed the PNQI by more than 80 percentage points. To put it into perspective, a $100 investment in PNQI five years ago would now be worth $202.26. This represents a compound annual growth rate of over 15%, which is a very good absolute return. Another interesting feature of internet companies is high volatility. Until recently, the performance gap between the NASDAQ and the PNQI was relatively small. However, the gap widened significantly from December 2021 when market volatility started to increase.
If we step back and look at performance from a 10-year perspective, the results don’t change much. The Nasdaq again finished on top and significantly outperformed the PNQI. However, it should be noted that PNQI has delivered strong results and outperformed Nasdaq through November 2021. I think it’s now pretty clear that you may face higher drawdowns if you own PNQI. This has been the case many times, including during the 2018 pullback and the COVID-19 crash. Before you consider buying PNQI, I think it’s important that you have a clear risk mitigation strategy. Using put options is an effective way to hedge risk, although it can be expensive at the moment given the current level of volatility.
Key points to remember
PNQI provides exposure to a basket of companies engaged in Internet-related activities. This ETF has performed well over time, accumulating a double-digit rate over the past decade. However, it is important to point out that the market also performed very well during the same period. If we take the example of the NASDAQ 100, it has indeed outperformed the PNQI. Given that we are at a turning point in monetary policy in Western economies, high multiple equities, like many constituents, are in my opinion risky investments at this time. I think it’s prudent to wait for more clarity on monetary policy decisions and see how the market reacts over the next 12 months before buying this ETF.