The Ins and Outs of HOLDRs

On any given day, HOLDRs will typically be among the top trading volume securities on the American Stock Exchange.

Merrill Lynch’s HOLDRs are grantor trusts that resemble ETFs, but aren’t registered or managed the same. Instead of charging an annual expense ratio, HOLDRs charge a small custody fee that varies depending on the number of shares owned. Also, unlike traditional ETFs, HOLDRs can only be purchased in 100-share or round lot increments.

While these product differences are important, they are probably superseded by other more vital inner workings.

Traditional ETFs are designed to track a specific index or benchmark. As stock or bond holdings in the underlying index are added or deleted, the ETF manager makes the necessary adjustments.

In contrast, each of the HOLDRs is a loose collection of stocks in a particular industry sector. As stocks with in a particular HOLDR trust merge or disappear, they aren’t replaced or rebalanced. As a result, HOLDRs have the propensity to become concentrated in the remaining stock holdings. This creates lots of volatility, which is one of the reasons HOLDRs are such a hit with traders.

But for investors, they would do well to take a closer and harder look at the HOLDRs before biting.

In 2006, performance divergences for the several of the HOLDRs were hard to miss. For example, Semiconductor and Biotech HOLDRs performed much worse against ETFs tracking the same sectors. Why? It probably has to do with the fact that HOLDRs, as an unmanaged product, were zeroed in on the wrong stocks within each of these respective sectors.

The same holds true for others too.

The Oil Services HOLDRs (OIH) is concentrated in only 18 oil services stocks. Among top holdings are Baker Hughes, Inc., Transocean Inc., and Halliburton, Co. While some of these companies are industry leaders in the oil services sector, it’s hard to replicate an accurate reflection of the oil industry’s overall performance with only 18 stocks. The unintended consequences are performance returns that are likely to be magnified or dramatically varied, compared to corresponding index ETFs.

On the hand, the Energy Select Sector SPDRs (XLE) does a much better job of benchmarking the overall performance of the oil services industry. With approximately 33 holdings, not only does it offer more balanced exposure, but it executes by having a portfolio of stocks very similar to the Oil Services HOLDRs. In 2006, the Energy Select Sector SPDRs outperformed the Oil HOLDRs by a very wide margin of 9.65 percent.

Name

2006 Performance*

Semiconductor HOLDRs (SMH)

- 8.16%

Biotech HOLDRs (BBH)

- 8.49%