A microwave oven is simple until you try to do anything more than heat up a frozen burrito. The same goes for
, the exchange-traded baskets developed by
On the surface, these products seem perfectly simple. They are fixed baskets of 20 stocks that trade on the
American Stock Exchange
. But when you decide to put your money down, you'll need to know the nuances and twists. Like any financial product, they have quirks.
Although these products have been extremely popular, the facts are sparse. Even on the great wide Internet, information is hard to come by.
For both the experienced and the uninitiated, the following primer should explain everything investors need to know about these securities. (The tax consequences regarding HOLDRs can be very complicated. For the lowdown, see today's
Tax Forum .)
Although that acronym doesn't exactly roll off the tongue, it stands for
Holding Company Depositary Receipts
The first HOLDRs were created in mid-1998 to reassemble the spun-off parts of the Brazilian telecom company
portfolio consists of the
and still trades today.
This structure, initially created by Merrill in response to an isolated market event, was later expanded and applied to others areas of the market and other needs.
What You Get
With the purchase of a single security, you get a basket of 20 stocks. Unlike a mutual fund, you actually own all the underlying stocks. Rather than paying 20 commissions for 20 stocks, you pay one commission for the entire collection.
Like a stock, you can buy and sell HOLDRs shares throughout the trading day.
These portfolios are fixed. They don't have managers to change them, squeeze them and shape them. If a stock in one of the baskets disappears due to an acquisition, a new one will not be added to take its place. No manager exists to make that decision.
So the HOLDRs each start out with 20 stocks, but
that number can drop as mergers and acquisitions remove stocks. For example, the
B2B (Business-to-Business) Internet HOLDRs
only consist of 18 stocks, since
The existing HOLDRs are weighted according to market capitalization, meaning the bigger stocks have a greater influence over performance. In the future, you may start to see equally weighted baskets.
Right now, the nine existing HOLDRs (excluding the Telebras HOLDRs) are focused on narrow, often very new sectors of the market, including
. These nine portfolios consist of the 20 largest companies in their respective sectors according to market capitalization.
Two more sector HOLDRs, covering utilities and regional banks, are on the way. They won't stop there. In the future, you may see cross-sector HOLDRs that focus on investing styles like growth or value rather than specific industries.
How Much Do You Have to Buy?
You can only buy and sell HOLDRs in round lots or 100-share increments. To buy the minimum amount, you'll have to pony up anywhere from $3,900 for the B2B HOLDRs to more than $17,000 for the
. That restriction would certainly exclude many small investors.
Where Do You Buy Them?
To buy HOLDRs shares on the offering, you'll have to go to Merrill Lynch or another broker that's involved in the underwriting. Once they start trading, you should be able to buy them from any full-service or online brokerage firm.
Getting Your Hands on the Stock
With this structure, you own the underlying stocks in the HOLDRs, and you can get your hands on the actual stock.
You can go to the trustee, which holds the assets of the portfolios, and redeem HOLDRs shares for the stocks in the basket. (This redemption can only be done in increments of 100 shares.) You can then sell the losers for a tax loss and keep the winners if you like.
To exchange HOLDRs shares for the underlying stocks, you'll have to pay $10 per 100 shares or less, with the fees going to the
Bank of New York
, the trustee. If you don't want to incur this rather steep charge, you can just sell your HOLDRs shares in the open market like any other stock and pay a commission.
How Much Do They Cost?
If you buy shares on the initial offering you'll pay 2% of the amount that you purchase. If you wait until the HOLDRs start trading in the secondary market, you'll only have to pay a brokerage commission. You'll also pay a commission when you sell HOLDRs shares.
Think about the difference. If you go to an online broker and pay $29.95 to buy 100 shares of the
, you'll pay 0.3% of your purchase. If you bought on the offering you would've paid 2%.
You shouldn't expect these securities to soar on the offering like a stock IPO. The HOLDRs are structured to trade close to the portfolio's net asset value. It's pure, unbridled demand that sends the price of IPO through the roof. So you'll probably be better off buying HOLDRs shares in the secondary market.
As a HOLDRs owner, the only recurring fee is a $2 quarterly custody charge per 100 shares. Whatever portion of the fee that isn't covered by dividends will be waived.
With the existing HOLDRs, you're getting only 20 stocks in a very thin slice of the market. They're
very concentrated, which makes them susceptible to stark price swings. Since the end of February, the tech-laden
index has fallen 7.8%, while the narrow B2B HOLDRs is down 58% for the same period.
As the biggest stocks in these baskets blossom, the HOLDRs can also become heavily weighted in their top holdings.
At construction, a maximum weight for a single stock is usually capped at 20%. For the coming
Regional Bank HOLDRs
, the maximum weight for one stock is set at 10%. This initial cap could change for any upcoming products, so it's important to look closely at every prospectus.
Once these baskets start trading, however, that cap doesn't stay in place. One stock can command way more than 20% of the underlying portfolio if it experiences a stunning surge. In the Internet HOLDRs,
commands almost 30% of the portfolio.
Dwindling Number of Stocks
As stated, with mergers and acquisitions, stocks can leave the portfolio and the HOLDRs will never add replacements.
You do, however, own everything that's in the basket. Although a stock might leave the portfolio, you'll receive your due as a shareholder in any company that's being acquired. You'll get the appropriate amount of cash or stock. It will just show up in your brokerage account. The same thing will happen if one of the holdings spins off part of itself. The spinoff won't stay in the basket, but you'll get the appropriate amount of stock in your brokerage account, separate from what's in the HOLDRs.
Again, these baskets are unmanaged. That also means that dividends aren't reinvested. Dividends, minus any fees, will be delivered into your brokerage account.
Right now, you'll have a difficult time finding information about these products.
The American Stock Exchange's
Web site does carry some information. Merrill should have a HOLDRs Web site up shortly, which will include a cost-basis calculator for tax computations.
More Ways to Trade
You can also short HOLDRs or buy them on margin. A short sale is bet that a security will fall. You borrow the security and sell it into the market with the agreement that you'll buy it back at a later date and return to the lender. If the stock falls, you buy it back at cheaper price and keep the profit. If it rises, you lose.
Unlike individual stocks, HOLDRs can also sold short when their prices are falling (called shorting on a downtick), which some people might find attractive if the market is imploding. Options also trade on the Internet and Biotech HOLDRs and should be available for trading on all the HOLDRs products shortly.
Mail and Taxes
With the HOLDRs, you do own each and every stock in the basket. This means you will be receiving an annual report from every company in every HOLDRs portfolio that you own. If you own more than one, you should warn your mailman.
Too, the federal income tax laws treat owners of the HOLDRs as directly owning the underlying securities.
Send your questions and comments to
firstname.lastname@example.org, and please include your full name.
Dear Dagen aims to provide general fund information. Under no circumstances does the information in this column represent a recommendation to buy or sell funds or other securities.