ETFs May Change, but HOLDRs are Forever

April 01, 2001

" Put together a basket and you're off to the races"

Though they are often set aside or excluded in discussions about exchange-traded funds, the assets under management for Merrill Lynch's Holding Company Depositary Receipts, or HOLDRs, have been growing steadily right alongside standard ETFs.

Merrill launched its first HOLDR in June 1998. The product allowed investors, in a single transaction, to purchase shares of all 12 companies that emerged from the breakup of former Brazilian telecommunications monopoly Telebras.

The product has come a long way since then. For starters, there are now more than 15 HOLDRs, including most recently an oil services sector HOLDR.

HOLDRs are fixed baskets, typically containing 20 stocks, that trade as a single share, in much the same way standard ETFs do. But there are differences. ETFs are allowed to make substitutions in lock step with the indices on which they are based-for example, swapping shares of Sears for shares Home Depot-to keep pace with the Dow Jones substitution.

For a HOLDRs product, once the basket is fixed, it's fixed. So even if companies within the index are acquired, or worse, one goes belly-up, the only recourse is to eliminate the stock from the basket. No stocks can be added or substituted. And whereas ETFs have flexibility to adjust the value weightings of the individual components of an index, HOLDRs lack room to maneuver.

Once the basket is fixed, so too are the share amounts. The weightings, however, are relative and fluctuate with the market. So while no stock in Merrill's new oil services product accounts for more than 10% of the total HOLDR, in an older product like the Internet HOLDR, AOL TimeWarner accounts for 49% of the value.

The AOL TimeWarner example also illustrates how HOLDRs can become outdated, unlike indices that are rotated to be current and anticipate the market. Nearly 50% of the Internet HOLDR is composed of a multimedia conglomerate of which AOL's business-the Internet business-accounts for less than 20% of the total firm's operations. And there's the rub. In a highly volatile market, such as the one that currently exists, how long can a selection of 20 or so stocks remain viable? Who's the 'Peter Lynch' at Merrill Lynch picking the 20 stocks? Why aren't more firms like Merrill offering these products?

'There have been rumblings with respect to Morgan Stanley, Salomon Smith Barney, Charles Schwab & Co, Ameritrade and eTrade offering HOLDR-type products,' says Nuveen Investments managing director Gary Gastineau.

Most recently, stories attributed to an insider at Morgan Stanley Dean Witter said the firm is planning to launch a new line of stock basket investments resembling HOLDRs as soon as April. If it should do so, MSDW would be the first to offer direct competition for Merrill's stock baskets. MSDW, however, would not comment on its plans one way or the other.

The appeal of this type of product to a brokerage firm is easily understood, says Gastineau. 'You don't have to wait a long time for SEC approval, and once you have your approval for the structure, you can easily launch new products. Put together a basket and you're off to the races.'

Of course, in order to get them off the ground, there has to be the expectation that the investor is going to make money, says Gastineau. With both blue chips and technology stocks more than 20% off their peaks, MSDW and similarly situated brokerages will likely reconsider any immediate plans.

But longer term? 'I wouldn't be surprised if Morgan Stanley and Epoch Partners are going to enter the business,' says ETF International president James Pacetti. Epoch Partners, a San Francisco investment bank, is said to be looking at a collaborative effort to launch HOLDR-type products.

Indeed, while HOLDRs account for less that 10% of the total ETF marketplace, the funds have more than doubled in assets under management. In 1999, HOLDRs had nearly $2 billion in assets and accounted for about 5.5% of the ETF market place. At the end of 2000, the funds boasted upward of $5 billion in assets, which represented more than 7.2% of the overall ETF pie.

None of the products have built up the momentum to break an average daily trading volume of 1 million, however. The Internet HOLDR comes closest. For the year 2000, the basket had average daily trading volume of 892,106.

The shelf life of HOLDRs

The Internet HOLDR is not the only one focused on the Internet. Perhaps in response the extreme weighting AOL TimeWarner has taken in the original Internet product, or to provide a product that more accurately reflects the sector, Merrill has launched several more Internet/technology sector HOLDRs.Those are the B2B Internet HOLDR, the Broadband HOLDR, the Internet Architecture HOLDR and the Internet Infrastructure HOLDR. Conceivably, as new market trends emerge and new companies become dominant, Merrill will offer additional Internet HOLDRs that reflect those conditions.

(Merrill did not return repeated calls seeking comment for this article.)

Despite their apparent limitations, HOLDRs are here to stay, says Pacetti. 'The overall expense ratio is lower, and there's a higher degree of tax flexibility. An investor can also easily redeem the underlying securities, breaking them out of the HOLDR structure and hold the individual securities.'

HOLDRs use a redemption-in-kind mechanism that allows investors, for a $10 fee per 100 shares, to exchange the HOLDRs for the shares in the underlying companies. Because the shares are already held in trust, such a transaction is tax free. Investors could use this mechanism of breaking HOLDRs to weed out the undesirable shares in a particular basket.

HOLDRs have a minimum purchase requirement, which is stricter than standard ETFs. They can be purchased only in 100 share round lots, whereas although ETFs are sold in lots of 50,000 shares, it's not difficult to buy lots as small as 10 shares on the open market. With HOLDRs, however, it is not possible to buy fractional shares. Within the minimum lot of 100 shares are an exact number of full shares. But the round lot design makes it easier to issue and cancel HOLDRs.

'People who buy HOLDRs pay no management or maintenance fees,' says Herb Blank, president of New York-based QED International. The only other expense associated with HOLDRs is a 2 cents a share quarterly custody fee Merrill charges for holding the shares, but any portion of that fee not covered by dividends is waived.

HOLDRs appeal to Merrill's large retail client base-which is essential for any firm attempting to launch such a product, says Blank. He speculates that Nuveen may be the first firm to launch a competitor HOLDR-type product. Lehman Brothers, he says, flirted with the idea briefly but decided against it.

It is also believed that Merrill asserts that the no-action letter it received from the SEC to launch HOLDRs is exclusive intellectual property. Any firm launching the first product may have to challenge that assertion in court.