Dear Dagen: HOLDRs a Low-Cost Way to Own Internet Stocks

There's always a catch.

Fig Newtons are cheap at Costco but you have to buy them in bulk.

The same goes for shares of the new exchange-traded Internet portfolio from Merrill Lynch (MER Quote).

In September, Merrill launched a new vehicle called Internet HOLDRs (HHH:Amex), shares of which trade on the American Stock Exchange. (HOLDRs stands for Holding Company Depositary Receipts.)

This fixed basket of 20 Internet stocks includes America Online (AOL Quote), Yahoo! (YHOO Quote) and Amazon.com (AMZN Quote).

Internet HOLDRs Lineup
Company	Initial Weighting*
America Online(AOL Quote)	19.6%
Yahoo!(YHOO Quote)	19.6
Amazon.com(AMZN Quote)	11.4
eBay(EBAY Quote)	7.7
Excite@Home(ATHM Quote)	7
priceline.com(PCLN Quote)	4.9
CMGI(CMGI Quote)	4.3
Inktomi(INKT Quote)	3.5
RealNetworks(RNWK Quote)	3.3
Exodus Communications(EXDS Quote)	3.3
E*Trade(EGRP Quote)	3.1
DoubleClick(DCLK Quote)	2
Ameritrade(AMTD Quote)	1.9
Lycos(LCOS Quote)	1.7
CNet(CNET Quote)	1.5
PSINet(PSIX Quote)	1.5
Network Associates(NETA Quote)	1.2
EarthLink(ELNK Quote)	1
MindSpring(MSPG Quote)	0.9
Go2Net(GNET Quote)	0.7
*As of Aug. 31. Source: Merrill Lynch

You can purchase shares from any broker, online or full-service, at your regular commission rates. So rather than paying 20 commissions to buy 20 stocks, you pay just one commission to buy one security. The only recurring fee is a $2 quarterly custody charge per 100 shares. And whatever portion of that fee isn't covered by dividends is waived. So, in essence, the only cost of owning this security is the up-front commission.

Here's an inexpensive way to buy 20 big-name Internet stocks. But you can only buy shares in round lots, or increments of 100. That excludes many small investors. Shares of the Internet HOLDRs trust are currently trading at about 110, so for a round lot you would have to come up with about $11,000. And that's the bare minimum.

In effect, these securities are designed for people with portfolios in excess of $100,000. Think about it. The average investor probably wouldn't want more than 10% of a portfolio in the Internet sector.

Other than this notable limitation, this exchanged-traded portfolio looks pretty good.

For one, anyone can go to the trustee and redeem Internet HOLDRs shares -- in round lots -- and get the underlying stocks in return. This exchange costs $10 per 100 shares, and the fees go to the Bank of New York, the Internet HOLDRs trustee.

When you own shares of Internet HOLDRs, you actually own the underlying stocks. For tax purposes, if you exchange your HOLDRs shares for the underlying stocks, you can unload the losers, take the tax losses and keep the winners.

This fixed portfolio is weighted according to market capitalization, with the maximum weight capped at 20%. On Aug. 31, AOL and Yahoo! commanded 19.6% of the portfolio each.

Those concentrations could change as the companies' market caps fluctuate, but the stocks in the portfolio will remain roughly the same. New stocks will not be added to the underlying portfolio. If one of the 20 stocks is acquired by another company, it will disappear from the portfolio. In the Internet sector, that's almost a certainty. Already, EarthLink (ELNK Quote), one holding, is merging with another, MindSpring (MSPG Quote).

If one holding is acquired by another company, you will receive your share of whatever was paid for that stock, whether it's cash or stock in the acquiring company.

The underlying trust can be terminated under a few conditions, including if 75% of the owners of outstanding Internet HOLDRs shares vote to liquidate the trust. Otherwise, the termination date is the end of 2039.

The structure of this vehicle is not new. Last year, Merrill created a similar product for the spun-off parts of the Brazilian telecom company Telebras. The Telebras HOLDRs (TBH Quote) consist of the Baby Bras.

You can expect to see Merrill roll out more of these securities for different sectors in the future.

The product is a close cousin to other, more recognizable exchanged-traded portfolios, namely the Standard & Poor's Depositary Receipts (SPY Quote) and the Nasdaq 100 tracking stock (QQQ Quote).

But there are pronounced differences. The underlying portfolios of SPDRs and the QQQ are unit investments trusts, or UITs. The composition of these portfolios will change as their underlying indexes change. Also, you can only create and redeem shares in increments of 50,000, which makes this exercise only available to institutional investors.

Like SPDRs and other exchanged-traded instruments, HOLDRs have a built-in arbitrage mechanism that should keep its share price trading close to the portfolio's net asset value, or NAV. So unlike closed-end funds that have a fixed number of shares, you shouldn't see a dramatic premium or discount develop between the price of the security and the NAV.

If a spread opens up between the HOLDRs and their underlying stocks, an investor should be able to capture that difference by trading in those securities for actual shares and selling those shares in the open market, or vice versa.

The price of the 20-stock basket can be tracked via the ticker (HHI.X Quote). Wednesday, the closing price of that basket was 110.53. Internet HOLDRs closed at 110.8125, a slight premium.

So far, Internet HOLDRs seem popular. There's $686 million in the portfolio, and more than 600,000 shares trade every day.

If you're interested, you just have to come up with the $11,000 to play.

Send your questions and comments to [e-mail], and please include your full name.