Editor's Note: This story was originally published Sept. 5, 2003 on RealMoneyExchange-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), 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.
Question: 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? Answer: Dividends are handled in different ways, depending on the ETF or HOLDR. Most ETFs, including the SPY and the QQQ ( QQQ), 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.