Editor's Note: This story was originally published Sept. 5, 2003 on RealMoney

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) - Get Report

, celebrated its 10th birthday last year, and more than 400 ETFs now exist worldwide.

Moreover, in the wake of alleged corruption in the mutual fund industry as evidenced by 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. 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.

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.


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?


Dividends are handled in different ways, depending on the ETF or HOLDR. Most ETFs, including the SPY and the


(QQQ) - Get Report

, 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.


I heard a while back that there were going to be gold ETFs -- not made up of gold-mining or production companies, but the actual commodity itself. Is that going to happen? If so, when? Do you have any insights or information about it?


You are correct: There is a proposed gold ETF sponsored by the World Gold Council. If this ETF wins approval from the

Securities and Exchange Commission

, it would trade on the NYSE under the symbol "GLD," and Spear Leeds would be the specialist.

Whenever a new ETF is created, there is a 30-day comment period during which the public can submit comments on the proposed new ETF to the SEC. If there are no comments of substance, as determined by the SEC, the ETF is usually approved. In the case of the gold ETF, however, the SEC did receive public comments that are now under review. The timing for approval is now uncertain, and the product remains in limbo.

If you want to know more about how a gold ETF may affect the market, you may want to read this

interesting paper on the market impact of gold derivatives.


How do ETFs maintain the price ratio to the underlying index they represent? For example, I understand that the price of QQQ is pegged at 1/40th of the

Nasdaq 100

index. With QQQ usually being the most heavily traded stock on the exchange, if QQQ is bid up significantly, then the underlying stocks within the NDX must go up in price as well. What makes the underlying shares go up?


After an ETF is created, it trades in the open market and is driven by supply and demand, just like any other stock.

Arbitrage causes an ETF to track the underlying basket of stocks. An arbitrage opportunity occurs if traders can make a riskless profit with zero net investment or a rate of return greater than the risk-free rate with a riskless investment. When this occurs, arbitrageurs are able to take advantage of the price discrepancies until they are reduced. These price discrepancies may not be completely eliminated, but they will be diminished to within a no-arbitrage band -- a level where transaction costs eliminate any potential economic benefit to arbitrage.

To use your example, suppose there was huge demand for the QQQs and they went to a large premium to the Nasdaq 100. Instead of 1/40th the value of the index, let's say the QQQ was trading at 1/30th of the Nasdaq 100. In this case, arbitrageurs would simultaneously short the QQQs and buy the 100 stocks in the NDX. This action causes the ETF to track the underlying basket and keeps the market efficient.


Is a 100-share multiple lot a HOLDR requirement? Does the same requirement hold for other, non-HOLDR ETFs?


HOLDRs must be traded in round lots (100 shares) in order to maintain a whole share holding in each of the underlying stock positions. This also assists in the issuance and cancellation of HOLDRs.

As for your second question, technically HOLDRs are not ETFs, although they are often thrown into the same category. 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. With that said, you can trade in odd lots for most ETFs. To the best of my knowledge, HOLDRs are the only products that require round lot transactions.

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 the time this piece was written, 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.