An inexpensive way for ETF investors to access some undervalued sectors.
One nice thing for investors about exchange-traded funds is that they come in so many different sizes. Some are incredibly diversified, holding hundreds--if not thousands--of stocks, while others offer very concentrated exposure to a given sector or geographic region.
The quirky suite of equity sector-themed HOLDRS funds, issued by a Bank of America Merrill Lynch subsidiary, falls into the latter category. And right now, three HOLDRS ETFs (in technology, pharmaceuticals, and banking) are trading well below their portfolios' respective price/fair value valuations, as calculated by our equity analyst staff, and represent compelling opportunities for investors.
First, a quick primer on HOLDRS: While HOLDRS funds trade on an exchange, they do not-- unlike other ETFs--track indexes, and they do not add new holdings. Instead, they reflect whatever selections Merrill made at the funds' inceptions in 2000, with deletions taking place only as a result of corporate events such as mergers, acquisitions, and de-listings. Because Merrill doesn't reconstitute or otherwise tinker with its portfolios, the holdings coast along with the market.
These unusual rules have led to some strange current-day HOLDRS. Easily the oddest one (and the one that takes concentration to the extreme) is B2B Internet HOLDRS
Having said all that, we find most other HOLDRS generally to be good proxies for the respective industries that they cover. In addition, from a fee standpoint, HOLDRS portfolios require investors to make their purchases in round 100-share lots, with annual custody fees of $0.08 per HOLDRS share. Merrill waives these custody fees if the underlying securities fail to generate enough in dividends or cash distributions to cover the fees. For example, if a HOLDRS fund were trading at $50 per unit, investors would have to purchase 100 units for $5,000 and pay just $8 in total annual fees, which equates to a very cheap expense ratio of about 0.02%.
Right now, Morningstar's equity analysts' valuations of HOLDRS funds' underlying holdings reveal three HOLDRS funds to be incredibly inexpensive relative to the entire ETF universe. In fact, Morningstar.com's ETF screener shows that these three funds are among the 10 least expensive U.S. ETFs on a price to fair value basis, among all ETFs with a sufficient number of holdings covered by Morningstar's equity analysts. What's more, Morningstar's equity analysts generally have assigned "low (or at most, "medium") fair value uncertainty ratings to the stocks held in these three HOLDRS, suggesting that investors interested in these specific sectors can use these funds to get exposure to these sectors with fairly low risk, on top of the reasonable valuations and low fees. It's probably not surprising that the three funds in question are dominated by large-cap names and have fairly minimal small-cap exposure, since Morningstar's equity analysts generally find large-cap stocks to be cheaper than mid- and small-cap right now.
The three funds that we believe are especially undervalued follow.
Regional Bank HOLDRS
One important thing to highlight about this fund is its misleading label. Despite what its name would imply, the majority of this ETF's assets are invested in larger banking institutions that don't qualify any longer as regional banks. However, Regional Bank HOLDRS is a great way to get concentrated exposure to large national money-center banks, which Morningstar's analysts believe are significantly undervalued. The fund's top-three holdings--J.P. Morgan Chase
Internet Architecture HOLDRS
Given that HOLDRS funds came out in 2000, it is probably not surprising that so many focused on the Internet. In addition to the B2B Internet HOLDRS fund that we mentioned above, there are a wide variety of HOLDRS geared toward the Internet: Internet HOLDRS
Also an inexpensive ETF trading at 85% of fair value, this fund owns a large number of "big pharma" names. It has just 15 holdings, but the fund effectively is a bet on four stocks that comprise more than 70% of the fund's assets: Johnson & Johnson
Given that all three of these funds offer very little in terms of diversification, we'd urge would-be investors to treat these funds as investments to be implemented tactically as small satellite holdings. And, of course, in all of these spaces, investors have other ETF options. However, all such options carry higher fees, are less concentrated, and are less undervalued than the HOLDRS funds we highlight here.
We should note some final points about HOLDRS funds. HOLDRS are organized as grantor trusts, which exempt them from certain diversification standards that are required of open-end mutual funds. They also give investors undivided beneficial ownership in the stocks that they hold, meaning that HOLDRS owners can directly receive the dividends and disclosure documents (like proxies and annual and quarterly reports of each stock in the basket) as if they had owned each company individually. As such, investors have the right to take direct control of the shares of the underlying stocks any time they want. And because HOLDRS are static, there rarely are any capital gains distributions. This gives investors a lot of control over when capital gains are realized. This is because when investors cancel their HOLDRS fund, they pay a fee but don't realize any capital gains because the transaction is essentially an in-kind exchange of shares. Once investors own the underlying stocks, investors can sell the losers to offset current and future gains of the winners.
In the end, HOLDRS charge very low fees and can make great investments for investors who have a strong conviction about a specific group of stocks. As we note earlier, the above funds look very inexpensively valued and could make appropriate tactical satellite investments.