Dear Dagen: A Closer Look at Barclays' Proposed Exchange-Traded Funds

Herb Greenberg has made me a liar.

Just a month ago, I swore I wasn't going to answer any more questions about the Nasdaq 100 tracking stock (QQQ) or any related index product until autumn or some major calamity.

But Greenberg's two columns last week about Barclays Global Investors have brought me right back to the land of exchange-traded instruments.

On Tuesday, Greenberg broke the news that Barclays had filed with the Securities and Exchange Commission to start a slew of new open-end index funds that would trade on the American Stock Exchange. Then on Thursday, he sketched how this move by the world's largest institutional money manager is likely to start a flood of exchange-traded funds, eventually leading to the launch of actively managed ones.

But this coverage left some investors asking: How are these instruments going to work? And how does money flow into these funds, and how are shares created? I'll try to fill in some of the blanks here.

The Barclays products will look and trade like some existing securities on the Amex. They will be very similar to the extremely popular Standard & Poor's Depositary Receipts, or SPDRs (SPY); QQQs; World Equity Benchmark Shares, or WEBS, and Select Sector SPDRS.

All of these products are constructed to track a specific index, just like your typical index mutual fund. But they also allow investors to trade shares like a stock. While most mutual funds are priced at the end of each trading day, these instruments are priced all day long and can be traded throughout the course of each day.

The biggest differences between these products are the indices they track: SPDRs are shares in a trust that tracks the S&P 500; QQQs are shares in a trust that tracks the Nasdaq 100. You get the picture.

But there is also an important structural difference. The underlying structure for the SPDRs and the QQQs is a unit investment trust, or UIT. WEBS and Select Sector Spiders are structured as mutual funds, like the upcoming Barclays products.

For the average retail investor, this UIT-vs.-mutual-fund debate doesn't amount to much.

"There is a difference if you are an attorney," says Gary Gastineau, senior vice president of new products for the Amex. "There is also a difference if you are into really arcane topics."

For example, you have a board of directors on a mutual fund and not a UIT, Gastineau says. And mutual funds can reinvest their dividends in stocks, while UITs have to keep the dividends in cash, which might result in a very slight cash drag to the average investor.

Otherwise, they are much the same. Just like your average mutual fund, these products have an unlimited number of shares. However, shares of these instruments are created and redeemed, typically in 50,000-share increments, by large institutional investors, specialists and arbitragers.

When creating new shares, an investor has to go into the market and buy the securities needed to create a stated number of shares. That is how assets move into the actual trusts and funds. Ordinarily, a large investor would use the actual securities for a creation and redemption. But with an actively managed fund, the manager wouldn't want to reveal his entire portfolio of securities, so the creation process would involve the use of some securities and a level of cash.

"When you have actively managed fund, I would expect the creation unit to consist of partly securities and partly cash," says Gastineau. Perhaps 60% securities and 40% cash, he says.

This creation and redemption process is not something that the average retail investor is capable of doing. "A little old lady in tennis shoes, unless they are very nice tennis shoes, is not going to be creating and redeeming these things," says Gastineau.

Retail investors would buy and sell shares of these UITs or funds just like stocks. Get your broker (human or electronic) on the line and place an order. You will have to pay commissions on your trade, just like you would for a stock. The underlying trust or mutual fund will have its own expenses, of course, just like any mutual fund does now. Annual expenses on SPDRs, for example, are just 0.18%, the same as for the (VFINX)Vanguard 500 Index fund.

As for the possibility of being able to trade actively managed funds during the day, you'll have to be patient. "All of the applications in the near term are index funds of one variety or another," says Gastineau. "I would not say we are close to having a filing for an actively managed fund. We will get there but not yet."

You may want to backtrack and read some of the previous articles about these instruments: a general explanation of the QQQ, a lengthier description of the QQQ and a broader story that also covers SPDRs and Diamonds (DIA).

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