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ETFs Come In Different Flavors

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Although existing exchange-traded funds each track a particular index, they are not all created equal. How an ETF is structured can have subtle effects on its performance in the short term. For long-term investors, even these slight performance discrepancies can have important consequences, and it's been said that indexing is a "game of inches."

Today all ETFs come in one of two structures: unit investment trusts and management investment company. Merrill Lynch's HOLDRs, which are not considered true ETFs by most analysts, are grantor trusts.

Some of the first and largest ETFs were structured as unit investment trusts (UITs), including the SPDR 500 (AMEX:SPY), Dow Jones Diamonds (AMEX:DIA), Nasdaq-100 Cubes (AMEX:QQQ), and S&P MidCap SPDRs (AMEX:MDY). The UIT structure was originally selected for ETFs because it was cheap and easy to manage - for example it doesn't require a board of directors.


The Largest ETFs are Unit Investment Trusts
Name Ticker Net Assets % of Total ETF Assets Rank
S&P 500 SPDR SPY $43,438,956,080 36.28% 1
Nasdaq-100 Index Tracking Stock QQQ $20,332,254,000 16.98% 2
DJIA DIAMONDS DIA $5,848,677,120 4.88% 4
S&P 400 MidCap SPDR MDY $4,877,865,300 4.07% 5



Source: The American Stock Exchange

However, UITs do not have the same flexibility of the management investment company, such as the ability to immediately reinvest dividends, lend securities, and use derivatives in managing the portfolio.

Most ETFs have the management investment company, or open-end, structure. This more flexible structure allows for securities lending and enables the funds to be measured against their predecessor mutual funds by rating agencies like Morningstar and Lipper. The open-end ETF manager also has the discretion to immediately reinvest dividends, use optimization techniques to replicate index performance (hold fewer stocks than the benchmark), and use futures and options.

Generally, the UIT structure is well suited to highly liquid large-cap indexes. The open-end structure and the ability to use representative sampling techniques are more critical when tracking small-cap or less liquid benchmarks, since holding every stock in the index is prohibitively expensive.

The different dividend reinvestment policies for the two ETF structures have resulted in what analysts call "dividend drag." ETFs with the open-end structure can immediately reinvest (equitize) dividends, while UITs cannot. The ability to reinvest dividends results in outperformance in a rising market, and underperformance in a declining market.

However, the effects of dividend drag are so small - only a few basis points per year - that most investors probably won't even notice, at least in the short term.

There are two ETFs with different structures that both track the S&P 500. The iShares S&P 500 (AMEX:IVV) has the open-end structure, while the first and largest ETF, SPDR 500 (AMEX:SPY), is a UIT. The iShares S&P 500 was introduced in 2000 in bear market.


ETF 2001 2002 YTD (as of 6/13/03)
SPDR 500 -11.83% -21.54% 12.80%
iShares S&P 500 -11.94% -21.91% 12.60%



Source: Morningstar

It will likely take several more years of data before any meaningful conclusions can be drawn from this head-to-head comparison.

However, ETF dividend drag may soon become a moot point. According to the website, at least one of the trustee-custodians of the UIT structure ETFs has applied to the SEC for permission to take the steps necessary to equitize dividends and engage in stock lending.