Similar but by no means the same
Faced with a plethora of financial instruments, it is no wonder that investors can become confused. In the US, this is sometimes the case with Holding Company Depositary Receipts (HOLDRs) and exchange traded funds (ETFs), which at first glance appear similar. But a closer look reveals their distinct and different characteristics.
In fact, the only common ground they share is that both are baskets of domestic and international stocks that can be bought and sold on a US stock exchange. They also each boast relatively low expenses compared to the average US mutual fund. But this is where the similarities end.
HOLDRs were first introduced to the US market in 1998 by Merrill Lynch to cover a particular slice of an industry. There are currently 17 products including biotech, broadband, internet, telecom and pharmaceuticals, listed on the American Stock Exchange in New York.
Unlike ETFs, they do not track an index. Investors have direct ownership in the underlying stocks, which means they have voting rights and receive dividends.
In addition, for a small fee they can cancel a HOLDR and receive the underlying shares.
Capital gains tax will only be incurred if the individual shares are sold. The other main difference is that HOLDRs are static and their composition does not change unless there is a major event such as a merger or acquisition.
Once a stock is removed, it is not replaced. Moreover, if a company's share price within the HOLDR rises, the holdings cannot be whittled down.
By contrast, ETFs will see slightly higher turnover - but lower than in actively managed mutual funds - due to rebalancing of the underlying index and other factors.
One of the main criticisms of the HOLDR structure is that portfolios can become top heavy with a few stocks dominating. Industry estimates reveal that the average HOLDR has about 85% of its assets in its top 10 holdings.
For example, the B2B Internet HOLDR consists of six stocks and about 67% of its assets are focused on CheckFree Corp, an electronic bill passport.
This is because HOLDRs are structured as grantor trusts and are not subject to the rules and regulations set out for mutual funds and ETFs in the Investment Company Act of 1940. They are not obliged to meet the diversification standards and as a result can become very concentrated.
Another drawback is that unlike mutual funds, HOLDRs do not have to calculate daily NAVs, which makes it difficult for investors to determine if the offerings are trading at premiums or discounts to the underlying values of their portfolios.
It is easy to see why HOLDRs made a stir when they first appeared but many in the investment community believe that today investors can find a more diversified and tax friendly options among ETFs and conventional funds. HOLDRs are still popular with hedge funds that focus on short-term tactical allocations.
"When they were first introduced, HOLDRs were unique and were seen as an efficient way to gain exposure to small slices of a market," says Greg Ehert, senior managing director of State Street Global Advisers.
"One of the main benefits was that they were quick to launch, which was not the case with ETFs 10 years ago. ETFs were then a nascent market and it took a long time to bring products to the market."
"The advantage of HOLDRs was that they are trading tools that enable investors to get in and out of markets quickly, and to take bets," notes Jennifer Grancio, head of distribution at iShares Europe.
"At the time, they offered access to parts of the market that were not available elsewhere such as biotechnology and the internet. That is not the case today as there is a much wider range of ETFs available. The market has also grown substantially compared to HOLDRs where assets under management have been fairly stable at around $10bn (€7.4bn) over the past few years."
By contrast, the ETF growth story has eclipsed even the industry pundits' wildest expectations.
The US, which is the largest market, boasts a weighty 343 products with $406bn of assets under management, according to research conducted by Debbie Fuhr, managing director, investment strategies, at Morgan Stanley.