Diamonds You May Want to Befriend

Get used to hearing about Diamonds.

These are not glittering rocks, but rather a brand-new investment product that acts like an index fund, trades like a stock and is actually neither.

The bottom line: If you wish to invest in the companies in the Dow Jones industrial average and like the idea of being able to trade and track that investment all through the trading day, you’ll like Diamonds.

At least originally, Diamonds was an acronym for Dow industrial average model new depositary shares. Even officials at the American Stock Exchange, which created the product and opened trading in it late last month, have to look that up. They now say that Diamonds is nothing more than a nickname, a playful term using the first letters for the Dow industrial average.

That’s appropriate, because Diamonds let investors play the Dow; only a handful of traditional mutual funds even attempt to mirror any part of the Dow.

Technically, a Diamond is an “exchange-traded unit investment trust.” Functionally, that means it lets an investor trade “the Dow” as easily as a single stock, as closed-end funds do.

Unit investment trusts have been around as long as mutual funds and are often packaged in a way that makes them look similar.

Many brokerage houses that offer unit trusts call them something like a “defined assets fund.”

Typically, these firms package a set portfolio of their top stock picks for the coming year, a portfolio of bonds, or of the so-called Dow dogs. (These are the stocks among the 30 Dow industrials that have lagged in the past year but that have high dividend yields and are thought likely to rebound in the coming year.)

You get the set portfolio of stocks or bonds for a limited time. Because the portfolio is not changed, ongoing management costs are minuscule. In the case of Diamonds, the trusts are set to expire in 2118--long enough that you don’t have to worry about the tax consequences of the trust being dissolved and all the shares sold.

Unit investment trusts have never gained much popularity, possibly because they are hard to understand, difficult to follow in the daily newspaper or through online resources and, in large measure, because of the brokerage commissions involved.

Diamonds--which are sisters to the Amex’s Spiders (Standard & Poor’s depositary receipts, based on S&P; indexes) and Webs (world equity benchmark shares, based on international indexes)--may change that.

Because they are traded on the Amex--Spiders are routinely among the exchange’s most active listings--prices can be tracked by the minute. The investment objective is clear to anyone who understands index investing. And although commissions remain a problem, using a discount broker can reduce that pain.

Still, investors who have jumped on the index fund bandwagon may wonder why they would ever pay a commission to get off. The Amex products have several answers.

Index funds are known for low expenses and tax efficiency, and Diamonds and Spiders do better at both.

Compare the Spider that tracks the Standard & Poor’s 500 (ticker symbol: SPY) with the Vanguard Index 500 fund, the largest mutual fund that does the same thing.

The Spider has an expense ratio of 0.185%, a fraction less than that of the Vanguard fund. That means it tracks the index a hair more closely.

When it comes to taxes, the gap is wider. Spiders have paid just 9 cents in capital gains distributions in the last five years; the Vanguard fund paid out six times that much in 1997 alone. (And index funds lose their tax efficiency if investors bail out during a market downturn; Spiders--for reasons too technical to cover here--do not.)

The Vanguard fund has a $3,000 minimum initial investment, the Spider has none.

One edge for the funds over Diamonds and Spiders: You can’t automatically reinvest dividends in the Amex products.

But because Spiders and Diamonds trade throughout the day, you can buy or sell in the middle of the day and get the current price, whereas with a mutual fund, you get the fund’s price at the end of the day. At times when the market is particularly volatile--such as last fall, when the Dow took some big swings--that can mean the difference between bailing out before a crash and going down with the ship.

“Between the tax efficiency over the life of your investment and the one day when you want to sell at 10 a.m. rather than 4 p.m., we believe that the Diamonds and Spiders more than overcome the problem of paying a sales commission,” says Jay Baker, vice president for derivative securities at Amex.

For most long-term investors, or for investors in tax-advantaged accounts, experts say it can be an either/or proposition in which you decide between a traditional fund and the market-traded investment trusts for your index holdings.

“For people who really and truly have thought out their investment goals and are trying to get a specific investment in its purest form, this makes a lot of sense,” says Steve Janachowski, of the Tiburon, Calif., investment advisory firm Brouwer & Janachowski.

Want more information about Diamonds, Webs and Spiders? Check out the American Stock Exchange site at https://www.amex.com