For Some, HOLDRs Have Become Too Successful

When Merrill Lynch (MER Quote) launched its HOLDRs last September, these exchange-traded baskets of stocks looked like the perfect way to invest in a hot sector or two.

Take a closer look.

Now that the oldest HOLDRs have been trading for a few months, two obvious flaws have appeared.

As their underlying stocks soar, these fixed baskets can become prohibitively expensive to buy and heavily weighted in their top holdings.

HOLDRs, which trade on the American Stock Exchange, already carry an investment restriction that prevents many small investors from buying shares. You can only buy and sell these products in increments of 100 shares, called round lots.

When the original Internet HOLDRs (HHH Quote) launched in September, a round lot cost about $10,000.

Now, 100 shares will cost around $15,800.

For many investors, the expense hasn't proved to be much of a barrier. After all, the seven HOLDRs portfolios have taken in more than $5 billion in assets.

But the sticker shock is even worse for Biotech HOLDRs (BBH Quote). They are up 69.7% this year and have soared 133% since their late November debut. A single share, which originally sold for around $100, now costs about $240.

But you can't buy just one share.

A round lot these days requires a $24,000 investment.

Conventional wisdom tells you that no more than 10% or 15% of your portfolio should be in a single sector like biotech. That limit means you should have a portfolio of at least $240,000 to own Biotech HOLDRs.

Many people will surely argue that these securities are still worth the $24,000. They're only costly because they've experienced such great performance.

But if you've been waiting to buy some Biotech HOLDRs, you may have waited too long.

Even though other exchange-traded portfolios can split, HOLDRs cannot.

The widely loved Nasdaq 100 tracking stock (QQQ Quote) will experience a 2-for-1 split on March 17.

Investors in the QQQ will receive two shares for every one they own. The split will cut the QQQ's current price -- around $222 a share -- in half.

Alas, a Biotech HOLDRs split won't happen.

One of the outstanding benefits of these products is the easy redemption in kind. An investor can exchange HOLDRs shares (in round lots only) for the underlying shares of stock in the corresponding portfolio. The exercise only costs $10 per 100 shares.

For the easiest exchange, the underlying HOLDRs portfolio shouldn't have fractional shares of stock -- only whole shares. A share split could create fractional shares.

Merrill could instead at some later date launch another Biotech HOLDRs basket that carries a lower share price, according to a Merrill official, who couldn't say when that might happen.

For now, investors who are yearning for these shares must come up with the required chunk of cash or wait for another series to come along.

Concentration Concern

As the stocks in these baskets skyrocket, investors should also pay close attention to the largest names in the portfolios.

They can become larger and larger -- to the point where the HOLDRs are dangerously top-heavy in a few stocks.

At launch, the holdings of each HOLDRs portfolio are generally weighted according to market capitalization, with the maximum weight of a single holding capped at 20%. That cap doesn't stay in place once the HOLDRs start trading.

(For the holdings of all seven HOLDRs, see my story from last weekend.)

A single stock can command way more than 20% of the underlying portfolio if it experiences a stunning surge.

Before the Internet HOLDRs basket started trading, both Yahoo! (YHOO Quote) and America Online (AOL Quote) each commanded 19.6% of the portfolio.

As of March 1, Yahoo represented almost 27%, while AOL had fallen to a 15.4% weighting.

Genentech (DNA Quote), the largest holding in the Biotech HOLDRs, had also surpassed the 20% mark as of March 1.

Many indices rebalance periodically to adjust the weightings to intended or initial levels.

Rebalancing helps maintain diversification among the sector or area of the market. The Nasdaq 100, for example, rebalances once a year.

"That's why indices rebalance. You want to maintain the spirit of a diversified exposure to a given sector," says Andrew Whittaker, vice president of equity derivatives research at Lehman Brothers.

Merrill will not rebalance the HOLDRs. In fact, the firm will not add new stocks to these baskets if one falls out after a merger. The Internet HOLDRs portfolio only has 19 now after the merger of EarthLink (ELNK Quote) and MindSpring.

Again, the easiest solution would be to launch a new HOLDRs series in the same sector and rework the weightings. In theory, holders of the old series could roll their investment into the new series, though there might be tax implications.

A somewhat less-convenient solution would be to redeem HOLDRs shares for the underlying stocks (in round lots only) and trim the biggest positions yourself.

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