An ETF Bet on the Net

The Internet HOLDR is good if you like eBay or Yahoo!, but lack of rebalancing could turn off some.
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Forget Yahoo!. Do you Internet HOLDRs?

Yahoo!

(YHOO)

shareholders weren't the only ones yodeling for joy after the company posted solid first-quarter numbers last week. When shares of the popular Web portal surged 8% to just under $34 Wednesday after the earnings report, the

Internet HOLDRs

(HHH)

exchange-traded fund rose 4% to $60.

That's because Yahoo! comprises more than 29% of the HHH, second only to

eBay

(EBAY) - Get Report

, which weighs in at 32%. The next two largest components in the ETF,

Time Warner

(TWX)

and

Amazon.com

(AMZN) - Get Report

, come in at 12% and 11% of the portfolio, respectively. Were it not for the immense Yahoo! and eBay stakes, those would be considered highly concentrated positions in comparison to other ETFs.

There's more to like about the HHH for you Yahoo! fans who are really taking sides in the Internet search war, or for those who believe that shares of rival search giant

Google

(GOOG) - Get Report

have gotten too ahead of themselves --there is no Google in the HHH, even though it is often referred to as an Internet ETF.

The HHH was rolled out in September 1999 near the peak of the Internet bubble -- which explains its dismal results in 2000, 2001 and 2002, when it lost 76%, 11% and 28%, respectively. The HHH turned with the rest of the tech market in 2003 and 2004, rising 102% and 42%.

Google started on its fantastic voyage as a public company in the summer of 2004. Had it been a member of the HHH portfolio, its sensational rise from its IPO price of $85 to its recent price near $450 surely would have goosed the fund's returns. Nevertheless, Google was never added to the HHH because HOLDRS, by design, are not like your average index-based ETF.

Like other ETFs,

Merrill Lynch's

(MER)

HOLDRs, short for "holding company depositary receipts," allow investors to own a diversified group of stocks in a single investment that is highly transparent and liquid.

However, HOLDRs are selected on an objective basis, such as market capitalization or P/E ratio, as opposed to being attached to a specific index.

And once the HOLDR starts trading, the baskets aren't rebalanced as they are with other index ETFs, which is why Google hasn't been added to the HHH even as the Internet stock has joined the

S&P 500

index.

Without the rebalancing, the proportions of stocks within the HOLDRs can change drastically as a result of dramatic price moves of the companies in the basket, at times leaving an issue heavily concentrated in just a few names. This can leave the rest of the portfolio with meaningless stakes in companies that are no longer relevant.

For instance, the HHH holds a tiny 25-basis-point stake in

CMGI

(CMGI)

, a stock that jumped to $200 a share during the bubble but now trades at less than $2 a share. The percentage of holdings in Yahoo! and eBay increased to dominate the portfolio to make up for CMGI's massive decline.

"The HOLDRs are often misunderstood by investors because they are not actually ETFs," says Sander Gerber, CEO of XTF Advisors, an ETF-based portfolio provider. "There is no index methodology to it."

The dangers of an overly concentrated portfolio were seen last week. On the day after the HHH rose higher on Yahoo!'s coattails, the ETF was dragged back down to earth when the other pillar of the portfolio, eBay, offered earnings guidance that failed to excite Wall Street. eBay fell 8% after its earnings report, while the HHH dropped more than 3%.

"I like the Internet as a sector, but not the HHH as a way to play it," says Ron DeLegge, editor of ETFGuide.com. "With only 12 holdings, it lacks key exposure to the Web's most important companies like Google,

Expedia

(EXPE) - Get Report

,

IAC/InterActiveCorp

(IACI)

and

Sabre Holdings

(TSG) - Get Report

, the company behind Travelocity."

Also, investors can only buy and sell HOLDRs in round lots of 100 in order to represent whole-share interests in each of the underlying securities, according to Merrill. This is designed to facilitate the issuance and cancellation of HOLDRs.

Unfortunately, that direct ownership also means that the wash-sale rule applies to HOLDRs, unlike other ETFs. Therefore, investors looking to swap out of a losing Yahoo! or eBay position and into the HHH in order to take a tax loss wouldn't be able to do so within 30 days; the wash-sale rule holds that you can't deduct a loss from a security on your tax return if you buy a "substantially identical" security 30 days before or after the sale.

One advantage of HOLDRs, especially for cost-conscious investors, is that there are no management fees of any kind. The only expense comes from transaction costs and from a small annual custody fee taken against cash dividends and distributions when they are issued.

Investors looking for a less restrictive, more diversified technology ETF may want to opt instead for the

iShares Dow Jones U.S. Technology ETF

(IYW) - Get Report

, which boasts

Microsoft

(MSFT) - Get Report

as its biggest holding, making up 12% of the ETF. Microsoft is followed by

IBM

(IBM) - Get Report

and

Cisco

(CSCO) - Get Report

at 6.5% of assets each. Another tech-ETF option is the

iShares Goldman Sachs Technology Index ETF

(IGM) - Get Report

, which also has Microsoft at the top, but with only 8% of assets. The expense ratio for the IYW is 60 basis points, while the IGM charges 50.

In either case, these ETFs, unlike the HHH, are not overrun by any particular holding. Google comprises around 3% of each portfolio and Yahoo! doesn't crack the top 10.

DeLegge suggests a pair of cheaper alternatives for investors seeking dot-com exposure: the

Technology SPDR

(XLK) - Get Report

or the

Vanguard Information Technology VIPER

(VGT) - Get Report

, both of which charge 25 basis points apiece.

"The problem with the Internet HOLDRs, like all HOLDRs products, isthe portfolios aren't maintained," says DeLegge. "Stock holdings aren't replaced or rebalanced when a company gets acquired or goes out of business. It's like an overgrown garden in need of trimming."

On a good day for Yahoo! or eBay, it's like the garden of Eden. On a good day for Google, however, it may be more like the garden of envy.