The Curious Case Of The B2B Internet HOLDRS (BHH)

by on April 6, 2010 | ETFs Mentioned:

When analyzing the ETF industry, investors love to know which fund has the lowest expense ratio (SCHB and SCHX both come in at 0.08%), most assets, or highest trading volume (both of these honors belong to SPY). Another record holder in the ETF space is the B2B Internet HOLDRS (BHH), although its distinctions are perhaps a bit less desirable. This product (it’s not technically an ETF) gives the largest allocation to a single stock, as Ariba Inc. (ARBA) accounts for a whopping 88% of total assets. And the remaining 12% weight is given to Internet Capital Group (ICGE), giving BHH the fewest components of any equity ETF. That’s right, BBH has only two holdings. It is also currently trading around $0.45 per share, giving it the lowest per share market value of any U.S.-listed ETP.

HOLDRS are different from traditional ETFs in several ways (see Five Facts Every ETF Investor Should Know About HOLDRS). For one, the annual custody fee is not a percentage of assets, but rather a flat $2 fee for every round lot of 100 HOLDRS that is “deducted from any cash dividend or other cash distributions.” So for BBH, that would imply an effective expense ratio of more than 4% (Merrill Lynch waives any fee that exceeds cash distributions, so that 4% figure represents the maximum possible expense ratio).

Another unique characteristic of these funds is the manner in which they deal with acquisitions and divestitures. On the surface, the fact that BHH has lost more than 99% of its per share value since the fund launched is alarming. But there’s more to this number than meets they eye, just as there’s a perfectly reasonable explanation for why there are only two components at present.

BHH’s prospectus notes that “the companies whose securities were included in the B2B Internet HOLDRS at the time B2B Internet HOLDRS were originally issued were generally considered to be among the 20 largest and most liquid companies involved in the B2B segment of the Internet industry,” indicating that once upon a time BHH was more than just ARBA and ICGE.

So what happened? The explanation is actually pretty simple.

HOLDRS treat acquisitions of underlying companies differently than most ETFs. If a stock included in a HOLDR is acquired, investors in the fund are treated as if they own the stock directly (i.e., they receive a cash distribution). So following an acquisition, there’s no rebalancing. The acquired stock is simply removed, the cash proceeds from the sale are paid to investors, and the fund continues to trade.

Dot.com Holdovers

As the name of BHH suggests, this fund was a product of the dot.com craze, and it originally consisted of 20 companies offering business-to-business products and services via the Internet. So it shouldn’t be surprising that many of the original BHH components have either been acquired or filed for bankruptcy (if anything, it should be surprising that two of the original 20 are still standing–that’s an impressive long-term success ratio for early 2000s era Internet startups). Shortly after BHH began trading, components began to drop out as they either became acquisition targets or folded:

  • March 2000: SBC Communications acquired Sterling Commerce.
  • April 2000: Kana Communications acquired Silknet Software
  • June 2000: Peregrine Systems acquired Harbinger Corporation
  • September 2000: Healtheon/Web MD acquired CareInsite, Inc.
  • August 2001: Ventro Corporation merged with NexPrise
  • July 2002: Scient Corporation filed for bankruptcy and was bought by SBI Group.
  • January 2003: The assets of bankrupt PurchasePro.com were sold for $2.5 million after a series of accounting scandals doomed the Internet startup.
  • April 2003: Kinko’s reached a deal to acquire ImageX.com
  • January 2004: Ariba, Inc. announces its plans to purchase FreeMarkets, Inc. for nearly $500 million
  • July 2004: Trinity Ventures completed its go-private transaction of SciQuest, Inc.
  • September 2004: Inovis International agreed to purchase QRS Corporation for about $116 million.
  • December 2004: 39 patents owned by bankrupt software company Commerce One, Inc. were sold off in an auction
  • March 2005: Oracle announced that it had purchased Retek after SAP dropped out of the bidding.
  • December 2005: Pegasus Solutions was acquired by an equity group led by Prides Capital Partners
  • May 2007: Oracle acquired Agile Software Corporation
  • July 2007: iCrossing acquired web development firm Proxicom
  • December 2007: Fiserv acquired CheckFree Corporation
  • January 2008: BravoSolution completed the acquisition of VerticalNet, a vendor of supply management software solutions.

So that’s how BHH got to where it is today, essentially an alternative way to buy Ariba stock with a side of ICGE. It’s somewhat surprising that there are still about 9 million shares of BHH outstanding, and that the average daily trading volume exceeds 25,000 shares. If one of the two remaining components gets snatched up or goes under, it will certainly be interesting to see how BHH reacts.

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Disclosure: No positions at time of writing.