To HOLD or to Fold?

On any given day, HOLDRs are among the highest-volume securities traded on the American Stock Exchange, but a cloud of confusion still surrounds their inner workings — especially how they differ from traditional exchange-traded funds (ETFs).

While both HOLDRs and ETFs each allow investors to buy and sell a basket of securities throughout the day, that’s pretty much where the similarities between them end. Merrill Lynch’s HOLDRs (or “Holding Company Depositary Receipts”) are grantor trusts that resemble ETFs, but aren’t registered or managed in the same way. Instead of charging an annual expense ratio like an ETF, owners of HOLDRs are charged a custody fee that varies depending on the number of shares in their portfolio. On that note, unlike traditional ETFs, HOLDRs can only be purchased in round lots, or 100-share increments.

Other important differences shouldn’t be missed. 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 predefined collection of stocks in a particular industry sector. As stocks within a particular HOLDRs trust merge or disappear, they aren’t replaced or rebalanced. As a result, HOLDRs have the tendency to become concentrated in the remaining stock holdings. This creates lots of volatility, which is one of the reasons HOLDRs have emerged as such a hit with traders, but advisors might do well to take a closer and harder look at these securities before biting.

In 2006, performance gaps for several of the HOLDRs compared to their ETF counterparts were hard to miss. For example, the Semiconductor and Biotech HOLDRs (Amex: SMH and BBH) performed much worse than ETFs tracking the same sectors. Why? It probably has to do with the fact that HOLDRs, as an unmanaged product, happened to be zeroed in on the wrong stocks within each of these respective sectors.

“A Little Too Different?”

Likewise, the Oil Services HOLDRs (Amex: OIH) contain only 18 oil services stocks. Top holdings include names like Baker Hughes, Transocean and Halliburton. While these companies are admittedly leaders in the sector, it’s hard for such a concentrated portfolio to accurately reflect the entire industry’s performance. The unintended consequences are performance returns that are likely to be magnified or dramatically uncorrelated to the corresponding index ETFs like the Energy Select Sector SPDRs (Amex: XLE). With approximately 33 holdings, the Energy SPDR does a much better job of tracking the overall performance of the oil services industry. It not only offers more balanced exposure, but it executes through 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 and still generated substantial liquidity. “In 2006 our Energy SPDR averaged 23 million shares per day,” says Dan Dolan, director of wealth management for the Select Sector SPDRs. “It’s truly the benchmark in the energy space.”

In general, questions still linger about how well the HOLDRs represent their respective industry categories.

For example, the Internet HOLDRs (Amex: HHH) were concentrated in only 12 Internet stocks. Is it possible to track an accurate picture of this fast-developing sector with such a small and limited portfolio? Noteworthy omissions from this group are Web juggernauts such as E*Trade Financial, Expedia, Google, IAC/Interactive and Monster Worldwide. Without these leading companies, it’s hard to argue that the HOLDRs are an accurate reflection of the broader sector. In contrast, the First Trust Dow Jones Internet Index Fund (Amex: FDN) has roughly 40 holdings, which naturally creates broader exposure.