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Not every investment that looks like an exchange-traded fund actually is one. Merrill Lynch's HOLDRs have sold rather well over the past decade, but the surprising quirks built into their design should prompt Fools to invest in them only with great caution.
ETFs based on indexes, such as the S&P 500-tracking SPDRs, are passive in nature, without frequent changes in their composition. Every now and then, some stocks are added or removed from the index, and the ETF makes its adjustments. HOLDRs, though, were created to each be a completely fixed basket of stocks from a particular industry or niche.
That might sound good -- hey, the folks putting this investment together must have a lot of confidence in its holdings! But changes do happen. Some companies go out of business, and are removed from the HOLDR. Some are acquired, but their acquirer doesn't replace them in the HOLDR. Some simply become unattractive … yet remain in the HOLDR.
For instance, the B2B Internet HOLDR (NYSE: BHH ) debuted with 20 business-to-business (B2B) focused stocks. Now it contains… two, Ariba (Nasdaq: ARBA ) and Internet Capital Group. Ariba makes up 87% of the HOLDR, despite its so-so prospects as a stock today, with slow growth and meager earnings.
Had the investment been designed differently, it might hold shares of database powerhouse Oracle (Nasdaq: ORCL ) , which bought two of its original components. Or it might have added companies viewed very favorably today, such as American Capital (Nasdaq: ACAS ) , which offers financing to start-ups.
Part of the initial appeal of HOLDRs was that they gave you an easy way to invest in a niche and be instantly diversified -- as many mutual funds and ETFs do today. But many of them today are dangerously underdiversified.
Not so bad
A few HOLDRs won't make you wince as much as the B2B one will. The Semiconductor HOLDR (NYSE: SMH ) still owns 18 different stocks, but a mere three of them, Texas Instruments, Intel, and Applied Materials (Nasdaq: AMAT ) , make up more than 50% of the basket. Still, many sport strong track records and prospects. Applied Materials in particular stands to benefit from increased chip demand for mobile technologies, along with its new focus on solar technologies.
If you'd like an easy and more balanced exposure to these businesses, however, consider the SPDR S&P Semiconductor (XSD) ETF. Or just carefully pick a few companies yourself, as part of a portfolio diversified across many compelling industries. HOLDRs may have seemed like a great idea once, but most seem well worth avoiding today.
ETFs don't have to be niche plays -- Dan Caplinger shows you how they can form the perfect portfolio.