‘Basket’ Securities an Alternative to Traditional Mutuals

For individual investors seeking to build a diversified portfolio of stocks conveniently and with little money, there is finally a critical mass of alternatives to the traditional mutual fund.

They’re called “basket” securities, an umbrella term that refers to a growing number of investments such as Standard & Poor’s Depositary Receipts (or SPDRs, pronounced “spiders”), World Equity Benchmark shares (or WEBs), and other exchange-traded funds.

As the name would indicate, basket securities reflect a pre-assembled portfolio of stocks that you can invest in through just one transaction.

Each so-called WEB, for instance, represents a basket of stocks that reflect a single country’s stock market. In the case of SPDRs, the basket simply reflects shares of all the companies in the benchmark Standard & Poor’s 500 index of U.S. blue chip stocks. In that sense, SPDRs are very much like an S&P; 500 index fund.


“These things are going to explode [in popularity] in the next six months,” Thomas Mench, chairman of Mench Financial, a Cincinnati firm, says of basket securities in general. “I can assure you that mutual fund companies are cognizant of this fact.”

Among their advantages:

* Basket securities are more tax-efficient than most traditional mutual funds, meaning you control the main capital-gains issues.

* They can be bought or sold intraday, unlike mutual funds, most of which can be bought or sold just once a day.


* They can be purchased on margin. That means they can be shorted--in other words, you can make a bet that the value of these shares will fall in the near-term.

* Their management expenses are relatively low.

From 1993, when the original SPDR was created, to the start of 1996, there were just two basket securities: the original SPDR and the MidCap SPDR, which tracks the S&P; 400 mid-cap stock index.

Today, there are 32. And San Francisco-based Barclays Global Investors is on the verge of launching up to 11 new WEBs (focusing largely on emerging-markets countries) and up to 51 new exchange-traded funds that track benchmarks ranging from the S&P; SmallCap 600/Barra Growth index to the Dow Jones Consumer Non-Cyclical Sector index.

Recently, Merrill Lynch developed a new type of basket security called HOLDRs. Currently, there are two--one that represents a basket of 20 Internet stocks (ticker: HHH) and another that represents 20 biotechnology stocks (BBH). If the idea takes off, more will follow.

Unlike a traditional open-end mutual fund, all basket security shares trade on a stock exchange.

But don’t confuse basket securities with old-fashioned “closed-end” mutual funds, which are also exchange-traded. Closed-end funds have a fixed number of shares, and those shares can trade at steep discounts or premiums to the true underlying net asset value of the portfolio, depending on investor interest and demand.

Basket securities, on the other hand, have sponsoring institutions behind them. Those institutions stand ready to create or redeem securities as needed to keep the value of the securities trading at prices that closely, if not precisely, track the value of the underlying stocks.


The institutions aren’t altruistic: Their actions to keep the basket values in line are based on the profit potential in exploiting even small “arbitrage” opportunities between the basket securities and the underlying stocks.

In practice, it works: For instance, Diamonds, which track the Dow Jones industrial average, are priced at around 1/100th the value of the Dow at any given moment. When the Dow closed Monday at 10,947.92, Diamond shares (ticker: DIA) closed at $109.55.

Today, basket securities typically track an established market index. But they could track any collection of securities. In fact, there have been discussions between mutual fund companies and the American Stock Exchange, where all basket securities now trade, to create exchange-traded versions of actively managed mutual funds. This would require funds to reveal their holdings at all times. But it also would allow fund companies to do business with “market timers” without harming other shareholders.

“A number of fund companies have been working on this,” says James Pacetti, president of New York-based ETF International Associates, which consults with the AMEX.

Using ‘Baskets’ Versus Index Stock Funds

One obvious question: Why invest in a SPDR or a Diamond when there are regular no-load funds that invest in stocks found in those two well-known indices?

If you “dollar-cost average"--that is, if you routinely invest small amounts of money each month or quarter, which many investors do--you might indeed want to stick with a no-load index fund. Because basket securities trade like a stock, each time you purchase or sell shares, you will incur a commission from your broker.

But if you intend to make a one-time-only investment then a basket security can make sense, says Frank Stanton, an analyst with fund-tracker Morningstar Inc. who follows these securities.


For one thing, a SPDR charges annual management expenses of just 0.18%, comparable to the expenses of the Vanguard 500 and lower than most other S&P; 500 funds, which average 0.53%, Morningstar says.

Even Vanguard founder John Bogle Sr., the biggest proponent of index funds, says of SPDRs: “I have no ability to knock them. They are brilliantly designed investments.” But he worries that the securities will encourage more trading instead of long-term investing.

Of course, many investors would argue that the ability to trade shares of SPDRs or exchange-traded funds intraday gives basket securities a huge advantage over traditional index funds. After all, should the stock market plunge in a given day, investors in traditional index funds wouldn’t be able to sell until day’s end. Also, some fund companies discourage redemptions by requiring written notification. And some fund companies impose 1% to 2% redemption fees on investors who sell a fund less than six months or a year after purchase.

Tax Advantages of Basket Securities

Taxes are another big issue. Basket securities are inherently tax-efficient. That’s because they simply buy and hold the underlying portfolio. The investor incurs a gain, or loss, when he sells.

By contrast, regular mutual funds must annually distribute to shareholders any capital gains generated either by the manager’s trading whims or because the manager was forced to sell securities because some fund investors wanted their money back.

The new basket securities do have some potential drawbacks.

For one thing, some baskets require you to purchase shares in round lots of 100. In other cases, you may be able to purchase smaller numbers of shares, but it might not be cost-effective to do so. Since many of these securities currently trade at $100 or more a share, that means you may need $10,000-$15,000 up front. By comparison, the minimum initial investment for the average domestic stock fund is just $2,000.

Here are more specifics on three types of basket securities:

* Unit Investment Trusts. SPDRs, Diamonds and the Nasdaq 100 index shares are organized as exchange-traded unit investment trusts, or UITs.

But these are different from UITs of the past because of the presence of sponsoring institutions that work to maintain the security’s value at or near the market price.

One caveat: Because of their structure, UITs cannot immediately reinvest dividends. They can do so only once a quarter, creating what analysts call a “cash drag” on your portfolio. By comparison, mutual funds can automatically reinvest dividends daily.

* Exchange-traded funds. These represent the second-generation of basket securities, improving on the UIT structure, argues Creighton Cole, Barclays’ director of ETF Strategy.

For instance, WEBs, single-sector SPDRs (which track narrow industries such as energy or financial services), and the 51 new baskets that Barclays is working on are organized as investment companies, just like an open-end mutual fund. As a result, ETFs can reinvest dividends daily, eliminating cash drag.

However, “there’s still the bid-and-ask spread,” says Vanguard 500 fund manager Gus Sauter: Even though an exchange-traded fund will closely track its underlying index, it’s not always precise (UITs face the same problem). Sometimes, the basket security might be 1/16th of a point off the underlying index, Sauter says. In times of major order imbalances, this could theoretically widen--especially in illiquid indexes, he says.

Which is why Thomas Mench of Mench Financial recommends investors for now “stay with the major indices, because those will be the ones with the most liquidity.”

* HOLDRs. These are depositary receipts created by Merrill Lynch that reflect a specific basket of stocks. Right now, there are two--one that represents a basket of 20 Internet stocks and another that reflects a basket of 20 biotech companies.

With UITs or ETFs, the shareholder owns units of a security that reflect and track a basket of stocks. HOLDRs, on the other hand, give the shareholder actual beneficial ownership of the underlying stocks in the basket.

Take Merrill’s Internet HOLDR (HHH). Every round lot of 100 shares of HHH buys you 21 shares of America Online, 13 shares of Yahoo, 18 shares of and six shares of EBay among other Net stocks found in the basket.

The advantage: It takes only one trade (and commission) to buy all those stocks.

But when it comes time to sell the HOLDR, instead of receiving your investment’s cash equivalent, you would receive ownership of the underlying stocks. Then, it’s up to you to sell or hold those stocks.

There’s an inherent tax advantage with this structure, analysts say. For instance, merely redeeming the HOLDR is not a taxable event. You’ll only be hit with taxes when you sell any of the underlying securities at a profit.

The disadvantage: You have to actually manage the stocks once the HOLDR is unbundled. And, you’ll incur brokerage commissions each time you sell, on top of a custody fee for the stocks.

Another difference between HOLDRs and UITs or ETFs: HOLDRs don’t track an existing index. They are completely unmanaged; the stock lineup, once set is never adjusted.

UITs and ETFs, on the other hand, track existing indexes that are managed to a degree by S&P;, Dow Jones and other firms. Should a company in the S&P; 500 go out of business, for instance, S&P; will replace it. Should a company in HHH go out of business, it will not be replaced. You will then simply have a basket of 19 stocks, not 20.

“That’s one disadvantage of HOLDRs,” Mench says.

Still, Mench says, all of these efforts represent “a huge paradigm shift that’s starting to be recognized by individual and institutional investors.”

That shift: Mutual funds aren’t the only game in town.

* Times staff writer Paul J. Lim can be reached at


Basket Securities

Individual investors can use “basket securities” as an alternative to mutual funds to create a diversified portfolio of equities. There are 15 U.S. basket securities, shown below, as well as 17 foreign country “WEBs.” All trade on the American Stock Exchange.


*Avg. Vol. YTD Name Ticker (in thousands) Price Tot. Ret. Nasdaq 100 shares QQQ 8,453 $152.81 49.6%** SPDRs (S&P; 500) SPY 7,777 140.94 15.2 Diamonds (Dow Industrials) DIA 993 109.55 21.2 MidCap SPDRs (S&P; 400) MDY 786 78.97 9.3 ML Internet HOLDR HHH 550 145.38 43.1** Technology SPDR XLK 531 48.11 47.5 Financial SPDR XLF 347 24.03 3.4 ML Biotech HOLDR BBH 240 107.00 2.5** Energy SPDR XLE 160 27.03 17.3 Consumer Staples SPDR XLP 62 25.23 -6.3 Basic Industries SPDR XLB 53 23.63 8.8 Industrial SPDR XLI 36 27.63 13.2 Utilities SPDR XLU 20 28.59 -3.5 Consumer Services SPDR XLV 13 28.52 9.7 Cyclical/Transport. SPDR XLY 12 28.81 10.7


* Avg. daily share volume based on last three months trading. Volume for HHH and BBH are since inception.

** QQQ, HHH and BBH were launched in 1999. Return figures for QQQ returns are since 3/10/99; HHH since 9/23/99; and BBH since 11/23/99.

Source: Bloomberg News