The Lowdown on ETFs

Exchange-traded funds, or ETFs, are a quickly growing segment of the investment landscape, with more than $167 billion managed in ETFs and HOLDRs around the world. The first ETF, the S&P Depositary Receipt (SPY - commentary - Cramer's Take), celebrated its 10th birthday this year, and more than 400 ETFs now exist worldwide.

Moreover, in the wake of alleged corruption in the mutual fund industry as evidenced by the recent charges made by New York State Attorney General Elliott Spitzer, the need to look beyond traditional funds is stronger than ever.

Despite their growth, ETFs aren't always completely understood. Last week, I asked readers for their questions about ETFs and received a tremendous response. Here are some of the most frequently asked questions and my answers. Please continue sending me your questions, and I'll attempt to answer them in future columns.

Before we get started, here's a quick review of the terminology:

ETFs are closed-end funds that represent diversified baskets of stocks. Some track indices as broad as the Wilshire 5000 or Russell 3000, while others track specific industry groups and are much more narrowly focused.

iShares represent a wide variety of ETFs. They're liquid investment tools that track the performance of a market index. iShares are traded on the American Stock Exchange, the Chicago Board Options Exchange and the New York Stock Exchange.

HOLDRs are unit investment trusts that represent ownership of a basket of stocks. They are nonregistered securities and are therefore not the same as ETFs, although they are often considered to be similar investment vehicles.

---

Question: How are the dividends handled that are paid by the stocks in the ETFs? Are they passed through to investors at the time of the payment?

Answer: Dividends are handled in different ways, depending on the ETF or HOLDR. Most ETFs, including the SPY and the QQQ (QQQ - commentary - Cramer's Take), invest the proceeds from dividends in cash equivalents and distribute these dividends to shareholders at a predetermined time, usually at the end of the month or quarter. iShares reinvest dividends in the fund when they are paid. HOLDRs immediately distribute cash dividends to shareholders. Regardless of how these products choose to deliver dividends, this is a taxable event for shareholders, and it's taxed in the same manner as if the dividend was from an individual company.

---

Charles L. Norton is a principal of GNI Capital, Inc., a registered investment adviser that manages a hedge fund, GNI Partners, L.P., as well as discretionary private client accounts. Norton previously was a vice president in the equity research department of a New York-based hedge fund, where he was also a registered representative managing discretionary private client accounts. Prior to his experience on the buy side, Norton worked in the investment banking division of Salomon Smith Barney, where he was an analyst in the health care group. At time of publication, his fund was short QQQ, though positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Norton cannot provide investment advice or recommendations, he welcomes your feedback.