August 18, 2005

HOLDRs Vs. ETFs: What Investors Should Know

The rising popularity of exchange-traded funds (ETFs) has opened the door to other new investment products offered as alternatives to mutual funds. Among these are HOLDRs -- Holding Company Depositary Receipts -- a proprietary product of Merrill Lynch.

The first HOLDR was launched in 1998. There are currently 17 listed on the American Stock Exchange with assets totaling $9.3 billion. In comparison, ETFs number 175 and have over $245 billion in assets. While both products share low-cost, low-turnover, tax-efficient characteristics, HOLDRs are vastly different investment vehicles, though they are often lumped in with ETFs. In fact, many fund trackers, including the Investment Company Institute, do not even keep track of HOLDRs since they aren't issued by registered investment companies. There are other key differences to be aware of as well when comparing HOLDRs and ETFs.

Essentially, a HOLDR is a static basket of stocks selected from a particular industry. As a result, HOLDRs do not track an underlying index like ETFs, and represent a rather narrow slice of an industry. Not only are HOLDRs completely unmanaged, their components almost never change. Furthermore, if a company is acquired and removed from a HOLDR, its stock is not replaced. This can result in even more concentration and added risk. In contrast, indexes that ETFs invest in can change and rebalance with some regularity, and generally contain more components. Such is the case with Barclay's 'iShares' and Vanguard's ETFs called 'VIPERs' (Vanguard Index Participation Equity Receipts), which collectively track Standard & Poor's and MSCI indexes.

Unlike ETFs, Merrill Lynch determines the composition of each HOLDR, and the individual stocks' initial weighting. One HOLDR can vary radically from another. For example, stocks in some HOLDRs are initially equally-weighted, while other HOLDRs' allocations are based on such parameters as market-cap, liquidity, and price/earnings, among others. For example, the $1.42-billion Biotech HOLDRs (BBH) has more than two-thirds of its assets invested in only two companies, biotech giants Amgen (AMGN) [27.1%], and Genentech (DNA) [41.2%]. For investors who might have expected broader diversification with a number of biotech issues, this HOLDR poses greater stock-specific risk and courts high volatility.

"The majority of HOLDRs were based on some type of cap-weighting at the time of their launch," notes Scott Ebner, associate director of new product development at AMEX. "But others, like the Europe 2001 HOLDRs (EKH), and the Market 2000 HOLDRs (MKH), were initially equally-weighted. Investors should consult the specific prospectuses for each HOLDR."

The number of holdings in a HOLDR can vary widely. For instance, the tiny $21-million B2B Internet HOLDRs (BHH) comprises only six stocks in total, due to rapid consolidation in that industry. CheckFree Corp. (CKFR) alone represents a whopping 66.9% of its assets. In contrast, Europe 2001 HOLDRs (EKH) has 44 stocks, which helps to dampen volatility. HOLDRs typically don't place concentration limits on individual stocks. As a result, investors will have to look under the hood to determine what diversification they offer.

Unlike ETFs, investors in HOLDRs have direct ownership in the underlying stocks. As a result, they have voting and dividend rights. However, HOLDRs can be very expensive to buy since investors may only purchase them in round lots of 100. For example, the Biotech HOLDRs (BBH), priced at $188.87 as August 17, would require an investment of $18,887, excluding commissions. This restriction excludes most small investors from participating in certain HOLDRs. On the expense side, however, HOLDRs feature low costs. Shareholders are charged a transaction cost and an annual custody fee -- which amounts to eight cents per HOLDR -- taken against cash dividends and distributions. This fee is waived if no dividends or cash distributions are paid on any of the underlying stocks.

Also unlike ETFs, if an investor grows disenchanted with some poor-performing stocks in his HOLDR, he can "unbundle" it, thereby owning each underlying issue separately. (But once a single stock is taken out, the HOLDR cannot be put back together as a unit.) Subsequently, he can sell off the unattractive names, and take the related tax losses. The shareholder can also defer gains on his top-gaining stocks since he is incontrol of the decision to sell. Investors who unbundle their HOLDRs have to pay a cancellation fee of up to $10 per round-lot of 100 HOLDRs. However, this transaction is not considered a taxable event.

"HOLDRs offer two advantages to investors relative to ETFs," notes Srikant Dash, index strategist at Standard & Poor's. "First, they provide more of a thematic approach to investment and trading because they focus on such narrow sectors as broadband and Internet infrastructure. The other advantage is that the underlying shares can be redeemed much easier than with ETFs, opening up various trading strategies, like holding onto some stocks, while selling others. Investors can also go 'long' on some issues, go 'short' on others. This appeals to certain sophisticated individual investors who can use the lower redemption facility."

However, Dash cautions that HOLDRs are better suited for investors focused on short-term tactical allocation, not as a buy-and-hold product. "This is clearly not a product for a retirement plan, or a 401(k) plan, or for small investors. It's for people who are actively trading."





B2B Internet HOLDRs (BHH)


$21.0 million

Biotech HOLDRs (BBH)


$1.42 billion

Broadband HOLDRs (BDH)


$142.5 million

Europe 2001 HOLDRs (EKH)


$19.6 million

Internet Architecture HOLDRs (IAH)


$67.5 million

Internet HOLDRs (HHH)


$337.8 million

Internet Infrastructure HOLDRs (IIH)


$24.0 million

Market 2000 HOLDRs (MKH)


$49.2 million

Oil Service HOLDRs (OIH)


$1.53 billion

Pharmaceuticals HOLDRs (PPH)


$2.04 billion

Regional Bank HOLDRs (RKH)


$459.08 million

Retail HOLDRs (RTH)


$292.9 million

Semiconductor HOLDRs (SMH)


$1.65 billion

Software HOLDRs (SWH)


$268.6 million
Telecom HOLDRs (TTH)


$367.4 million

Utilities HOLDRs (UTH)


$516.0 million

Wireless HOLDRs (WMH)


$69.1 million

Source: American Stock Exchange. Data as of Aug. 12, 2005.

*There are also two HOLDRs listed on the New York Stock Exchange, including the very first HOLDR, Tele Brasil-Telebras Hldrs (TBH), formed in mid-1998 in connection with the break-up of Telebras, the Brazilian telecommunications giant, into 12 new companies. Another NYSE-listed HOLDR, the Merrill Lynch Canada Canadian Pacific HOLDRs (HCH), was formed in connection with split-up of the railway Canadian Pacific Ltd. into five separate publicly traded entities. This HOLDR also trades on the Toronto Stock Exchange.

Contact Bob Keane with questions or comments at:
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