You've Got to Know When to HOLDR 'Em

New, innovative exchange-traded funds covering commodities, currencies, and offering long and short strategies that push the boundaries of passive investing have gotten most of the attention recently. But we still get a lot of questions about an old standby: HOLDRs (Holding Company Depository Receipts). Investors often stumble across these close cousins to ETFs when looking for exposure to specific equity markets or market segments, which HOLDRs offer. The vehicles have some initial attractions--and some serious drawbacks. There are fewer than 20 of them on the market, and I'm not crazy about them because there are concentrated and hard to value. However, they are still worth knowing about because they are often some of the most actively traded exchange-traded portfolios around. (Semiconductor HOLDRs  and Oil Services HOLDRs  have been among the 10 most actively traded ETFs recently.) Furthermore, with more people than ever before trolling the ETF universe for investment ideas, we thought it would be a good time to look at the pros and cons of HOLDRs.

Hold What?
It's easy to confuse a HOLDR with an ETF. HOLDRs are essentially bundles of domestic, and in some cases international, stocks. Like ETFs they can be bought and sold throughout the day on the American Stock Exchange and have low expenses relative to the average conventional open-end mutual fund.

This is where the similarities end, though. Unlike ETFs, HOLDRs don't track indexes. They are baskets of about 20 or so stocks selected by Merrill Lynch to represent a market, sector, subsector, or industry. There are many more narrowly focused HOLDRs than broadly diversified ones; most of them focus on thin slices of the market, such as semiconductors, Internet, retail, regional bank, or biotechnology stocks.

Unlike ETFs, HOLDRs don't charge a management fee (but they don't offer a free lunch either, as we'll see later). Your only expenses are your transaction costs and a small annual custody fee taken out of cash dividends and distributions when they are issued. That annual custody fee of $0.08 per share is waived if the HOLDRs' underlying stocks pay no dividends.

HOLDRs also aren't organized as open-end funds or unit-investment trusts, but rather as grantor trusts. This means they aren't subject to rules and regulations set forth for mutual funds by Investment Company Act of 1940. This is more than just legalese. The 1940 act requires funds to meet diversification standards, but because HOLDRs are exempt they can and do get very concentrated.

As they are organized, HOLDRs also give investors "undivided beneficial ownership" in the stocks they hold. That means HOLDRs owners can directly receive the dividends and disclosure documents (proxies and annual and quarterly reports, for example) of each stock in the basket as if they owned each company individually. The structure also lets investors cancel their HOLDRs, or essentially take direct control of shares of the underlying stocks, for a $10 fee per round lot of 100 HOLDRs.

To HOLDR�
HOLDRs have some advantages. Investors can get direct ownership of a basket of stocks for one commission. It's easy to know what you own because the portfolios never change their holdings (though individual stock weightings do change as their prices rise and fall) unless there is a merger, acquisition, or bankruptcy. So, if you have a strong conviction that a group of stocks look attractive, you can buy them in one fell swoop.

Because HOLDRs are static there is no management fee and rarely any capital gains distributions. In fact, HOLDRs give investors a lot of control over when they realize capital gains. When investors cancel their HOLDRs, they pay a fee, but don't realize any capital gains because it's essentially an in-kind exchange of shares. Once they own the underlying stocks, investors can sell the losers to offset current and future gains of the winners.

�Or Not to HOLDR
Overall, these investments have limited appeal, though. They are very concentrated. Stocks can drop out of a HOLDR as a result of mergers, acquisitions, or business failures, but Merrill Lynch never adds new securities. This means the initial HOLDRs can shrink to just a handful of holdings. Merrill Lynch also doesn't trim HOLDR stocks as they appreciate, which means that a couple of constituents can dominate the vehicle. The average HOLDR has more than 85% of its assets in its top 10 holdings. B2B Internet HOLDRs , for example, now includes just six stocks and has nearly three fourths of its assets in electronic bill payment firm  Checkfree  (CKF)R. That's way too narrow to be anything but trouble to most investors.

HOLDRs also trade only in 100 share increments, which often makes them too costly for average investors. That wouldn't be an impediment to buying the aforementioned B2B HOLDRs, which at recent prices would require an investment of about $230, but it could become a significant hurdle for some of its siblings. Investors, for instance, would need more than $12,500 to buy 100 shares of Oil Services HOLDRs at recent prices.

The biggest drawback is that unlike mutual funds, HOLDRs don't 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.

In short, this is a rather high-maintenance way to invest. Most investors can find more diversified, competitively priced, and tax-friendly options among ETFs and conventional funds.

Morningstar Analyst Marta Norton contributed to this report.