ETFs Beat HOLDRS Hands Down!

By: Ron_Rowland

If you’ve been reading my Money and Markets columns for any length of time, you know I’m a big proponent of exchange-traded funds (ETFs). And I think they’re one of the most exciting investment innovations in decades.

However, one consequence of innovation is that eventually the latest-and-greatest products go past their “sell-by” dates. For example, I remember getting my first IBM personal computer back in the 1980s. It was state-of-the-art! Today it would be considered an antique.

So it is with ETFs. And today I’m going to tell you about a group of funds called HOLDRS …

What Are HOLDRS?

The acronym stands for HOLding Company Depository ReceiptS. They were introduced by Merrill Lynch during the late-1990s bull market. HOLDRS are typically classified as ETFs. But Merrill chose not to launch them as traditional ETFs, legally speaking, even though the ETF structure already existed at that point.

HOLDRS are essentially a basket of stocks. Various HOLDRS cover different market sectors: Biotechnology (BBH), pharmaceuticals (PPH), semiconductors (SMH), oil services (OIH), and so on. Buy the appropriate HOLDRS and you get exposure to the desired industry, just like an ETF.

HOLDRS used to be the only way to get a basket of pharmaceutical companies with one purchase.

Here’s the rub and one of the big differences between HOLDRS and regular ETFs: HOLDRS cannot add new stocks to their portfolio.

For a year or two after they came out, that wasn’t a big deal. Each of the HOLDRS had a good selection of companies from its sector. They grew quickly and became useful trading vehicles. Then the bear market came …

HOLDRS Get More Concentrated

Companies come and go even in the best of times. They get bought and sold, merged, go out of business, etc. No problem for an ETF that tracks an index. The index provider simply replaces departing stocks with new ones that are reasonably comparable.

This isn’t what happens in HOLDRS. Because stocks that disappear can’t be replaced, the HOLDRS assets are redistributed to those that remain.

Over time, this means many of the HOLDRS have become remarkably concentrated in very few stocks. The Broadband HOLDRS (BDH), for instance, have around 56 percent exposure to a single company, Qualcomm (QCOM), 14 percent in Corning (GLW) and 11 percent in Motorola (MOT). The remaining 19 percent is spread among more than a dozen smaller stocks, none of which really matter to overall performance.

So a trade in BDH is really a trade in QCOM, GLW, and MOT.

Maybe these stocks are good opportunities, maybe they aren’t. My point is that owning Broadband HOLDRS does not give you company diversification within the broadband sector. It just gives you a basket of three stocks. But if you like those three, BDH may work for you.

A few years ago, there were times when it made sense to buy some of the HOLDRS. That was before many of today’s ETFs had developed a market. Now, in every case, there is at least one true ETF covering the same sector as each of the HOLDRS — without the excessive company risk and without the other bothersome quirks, which I’ll go over in a moment.

Today, HOLDRS are mostly a plaything for day traders. Some of them are very active, volume-wise, but that doesn’t make them a good investment — especially if you intend to stick around for more than a few minutes.

Three More Reasons to Avoid HOLDRS And Stick with ETFs …

The lack of diversification should be enough to convince you that HOLDRS might not be the best route to go. Yet if you’re still considering them, here are a few more points to keep in mind:

• Most brokers require you to buy and sell HOLDRS in 100-share round lots.

You can buy a hundred shares, a thousand, and so on. But you can’t buy 50 shares, or 75, or 130, or any other number that isn’t a multiple of 100. This is especially annoying for small investors. For instance, Oil Service HOLDRS (OIH) is around $120 a share. That means you have to spend a minimum of $12,000 to get in.

You won’t find that kind of restriction with ETFs. Just like stocks, you can trade as few as one share.

• Your mailbox will be packed.

HOLDRS will keep your mailbox stuffed.

With HOLDRS, you are actually a legal owner of the shares of each company in the portfolio. That means you’ll get a constant stream of prospectuses, annual and quarterly reports, proxy requests, and other such paperwork, for possibly dozens of different companies.

ETF sponsors don’t make you deal with all this stuff.

• You’ll count your dividends by the penny.

Whenever one of the companies in a HOLDRS fund pays a dividend, it gets passed straight through to you. Dividends are nice, of course. But they’re even nicer when you aren’t getting blasted with several in the same week, usually in fractional amounts.

All this dividend action can quickly add up to an accounting nightmare. Moreover, when a company makes a spin-off or other special distribution, it can take weeks or months for the results to show up in your brokerage account.

ETFs pay you your pro rata share of dividends, if any, accumulated on the stocks held in an ETF, and interest on the bonds held in an ETF. There may also be the opportunity for dividend reinvestment.

Despite these flaws, I’m glad HOLDRS came along. They were a big step forward in the development of modern ETFs. However, their day in the sun has come and gone. Now they’re no longer the best alternative. So I suggest you consider sticking with actual ETFs and avoiding the problems of HOLDRS.

Best wishes,

Ron

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