Contrary to what you might expect, internet and social media exchange-traded funds (ETFs) have held up relatively well this year despite the slump in well-known names such as Facebook (FB), Groupon (GRPN), Zynga (ZNGA) and Angie’s List (ANGI).

Internet and social media ETFs have proved surprisingly resilient this year despite the slumping share prices of well-known names Facebook, Groupon, Zynga and Angie’s List.

Indeed, the PowerShares Nasdaq Internet Portfolio ETF (PNQI) and First Trust Dow Jones Internet Index ETF (FDN) are up 15.8% and 12.8%, respectively. And while the Global X Social Media ETF (SOCL) is in negative territory, down 3.7% year to date, this is probably less than most would assume given its pure-play exposure to social media names. [See Global X launches world’s first social media ETF (SOCL)]

Compared to the NASDAQ Composite Index, which is heavily weighted towards technology companies, the returns are less flattering. The NASDAQ has gained 18.1% so far this year.

However, bearing in mind that Facebook is down almost 50% since its IPO in May, and Groupon, Zynga and Angie’s List have all plummeted this year, down 77.5%, 68.3% and 38.8% respectively, the performance of the aforementioned internet and social media ETFs looks fairly respectable.

This highlights two important aspects of ETFs, which have aided the performance of these funds: diversification and index construction rules. Diversification helps smooth out stock-specific risk in a portfolio so that the positive performance of some holdings offsets the negative performance of others. Meanwhile index construction rules take into account factors such as inclusion date and free-float; typically stocks have to complete a “seasoning period” before gaining inclusion and are adjusted for free-float.

PNQI, FDN and SOCL are all highly diversified within their respective sector spaces. PNQI has 69 holdings, FDN has 41 holdings, and even SOCL, with its narrow focus on social media, is fairly well diversified with 34 holdings. SOCL diversification, for example, has meant that the negative performance of holdings such as Facebook, Groupon, Zynga and Angie’s List have been neutralised by the positive performance of holdings such as LinkedIn, the online professional network, and Tencent, the China-focused internet media company, which have rallied 63.3% and 60.6% respectively so far this year.

Index construction rules have also helped internet and social media ETFs. Once again using  SOCL as an example, despite an implied market cap of around $43 billion, Facebook occupies a much smaller position within the fund than, say, LinkedIn, which has a market cap of approximately $11 billion. This is because index weight is based on the total value of shares that investors can freely purchase on open markets, known as free-float-adjusted market-capitalisation weighting. With so much Facebook stock closely held and restricted, its weight within SOCL is less than half that of LinkedIn’s, despite it being almost four-times larger.

The seasoning period for new issues has also proved useful. The evaluation period prior to gaining admission to an index (and thus ETF), provides time for new issues to establish liquidity and withstand the onslaught of public scrutiny. It also allows time for any behind-the-scenes post-IPO “massaging” by underwriters to settle down. Essentially, this “cooling off” period provides time for new issues to find their fair market value before gaining inclusion into an ETF.

As a consequence of these provisions, SOCL avoided the initial drop in Facebook shares while FDN and PNQI are yet to add it. In fact, Facebook, Groupon, Zynga and Angie’s List are all still absent from FDN, and, of these, only Groupon has been added to PNQI.

With many active stock pickers (both private and professional) having had their fingers burned and wealth dented by the stock-market collapse of these “blue chip” social media names, the strong relative performance of  internet and social media ETFs provides yet another demonstration of some of the many benefits of investing via ETFs. While Facebook, Zynga et al are all likely eventually to gain inclusion into these ETFs, they will be added at considerably lower and more realistic valuations – once the initial hype and froth has been blown off.

Featured funds

Global X Social Media ETF (SOCL)
The Global X Social Media ETF (SOCL), the world’s first ETF to track companies operating in the social media sector, is the “one-stop shop” for social media exposure, including companies that provide social networking, file sharing, and other web-based media applications.  SOCL tracks a proprietary benchmark of social media stocks including names such as Facebook, Groupon, LinkedIn, Pandora, Google, Tencent, Sina and Zynga. SOCL is listed on the Nasdaq and has a TER of 0.65%.

First Trust Dow Jones Internet Index ETF (FDN)
The First Trust Dow Jones Internet Index ETF (FDN) is based on the Dow Jones Internet Composite Index. The Dow Jones Internet Composite Index is a blue-chip measure of internet-related companies. To be eligible for inclusion in the index, a company must currently be included in the Dow Jones US Index and also generate at least 50% of its annual sales/revenues from the internet. It is made up of approx 40 stocks: 15 from the Internet commerce sector and 25 from the Internet services sector. Major holdings include names such as Google, Amazon, eBay, Priceline, Salesforce and Yahoo. FDN is listed on the NYSE Arca and has a TER of 0.60%.

PowerShares Nasdaq Internet Portfolio ETF (PNQI)
The PowerShares Nasdaq Internet Portfolio ETF (PNQI) is based on the Nasdaq Internet Index. The Nasdaq Internet Index is designed to track the performance of the largest and most liquid US-listed companies engaged in internet-related businesses and that are listed on one of the major US stock exchanges. Major holdings include Amazon, eBay, Priceline, Google, Baidu, Yahoo and Groupon. PNQI is listed on the Nasdaq and has a TER of 0.60%.

(Performance numbers as of close August 20, 2012)