Actively-managed mutual funds have been out of favor in recent months because of two rapidly developing trends. Funds pegged to a market index, like Standard & Poor's 500, have gained in popularity, not only because they can outperform many actively-managed funds, but because they take less of a bite out of an investor's earnings through low management fees. In addition, the popularity of Internet stocks has drawn investors away from activelymanaged funds to invest in individual Internet stocks.
These market developments have stimulated the introduction of investment alternatives to mutual funds. At the end of September, Merrill Lynch, Pierce, Fenner & Smith launched one of these alternative vehicles that takes advantage of investors' interest in Internet stocks and their concern about the cost of owning a mutual fund.
The vehicle, called Internet HOLDRs (ticker: HHH), is a security traded on the American Stock Exchange backed by the common stock of 20 companies involved in various segments of the Internet industry.
Merrill's new HOLDRs arrives about a year after the company's introduction of Telebras HOLDRs (ticker: TBH), which represents the stock of 12 companies formed when Brazilian telecommunications giant Telebras was split up.
Internet HOLDRs are depository receipts issued by the Internet HOLDRs Trust, the legal entity which holds the stock and for which the Bank of New York acts as trustee. It differs from a mutual fund or Unit Investment Trust in that it represents an investor's undivided beneficial ownership interest in 20 of the largest and most liquid companies in the Internet industry measured by market capitalization and trading volume.
Shares in America Online and Yahoo make up about 40 percent of the HOLDRs portfolio with another 11 percent invested in Amazon.com. The portfolio's make up changes in the event of stock splits or acquisitions.
Unlike other depository receipts, owners of HOLDRs shares can redeem them with the trustee for shares in the individual stocks.
"The HOLDRs investment platform is designed to provide investors with a flexible, cost-effective way to diversify their investment in a particular industry through a single, exchange-listed security," said Steve Bodurtha, first vice president and senior director of Merrill's Customized Investment Group in a statement.
"In many ways, Internet HOLDRs represent a breakthrough for investors," he said. "Through HOLDRs, investors will be able to invest in and trade a variety of companies at costs that are expected to be lower than investing through other vehicles."
Investors pay a broker's commission - which can be as little as $7 - to buy the shares and two cents a share to redeem them. That compares favorably with Internet-specific mutual funds like the Guiness Flight Internet.com Index, which has an annual expense ratio of 1.25 percent, or Munder NetNet, which has a 5.5 percent sales load and expense ratio of 1.48 percent.
The HOLDRs product is similar to another alternative investment vehicle, SPDRs, or Standard & Poor's Depository Receipts. With a SPDRs (ticker: SPY), an investor invests in the shares of a trust that holds all the stock of the S&P 500.
According to Eliott Shurgin, vice president for Index Services at Standard & Poor's, the benefits of an alternative investment vehicle like SPDRs to investors extend beyond low costs. He said benefits include:
* They can be purchased at any time during the investing day.
* An investor can short them.
* They can be bought on margin.
In addition, there is no capital gains distribution to worry about at tax time with the vehicle.