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How to Invest in the Averages

How do you find a Diamond in a Spider Web? Just play the averages.

Index averages, that is. Today, I want to focus on the wide variety of index-tracking securities that anyone can trade now.

Until not that long ago, you had to have an options account to play the main market indexes. The most widely tracked index is the S&P500, the SPX. Lots of traders also follow the S&P100 (OEX) and the Russell 2000 (RUT) for small cap stocks.

But trading options usually means paying hefty premiums and getting ripped off on spreads and commissions. So the AMEX (you remember them, don’t you?) created index-tracking securities which you can trade in and out of as easily as IBM or MSFT. You can also short the index-trackers as a hedge against your long positions.

Most of these securities are called "Spiders" (SDPR’s). If you want to track the S&P 500, all you have to do is buy or short the SPDR which trades as "SPY".

But wait a minute, aren’t there zillions of S&P Index funds out there already?

Sure there are. If you want to pay Vanguard or Fidelity more money to do what the SPY does for less, go right ahead. But there is no reason to go with an index fund.

Each SPY share represents 1/10 the value of the S&P 500 average. That keeps the shares in the $100+ range, still affordable for small investors. The costs you pay are less than most index-tracking mutual funds, too.

The SPY was so popular that the AMEX decided to create a big brother to track the 30 stocks in the Dow Jones Industrial Average. The "Diamond" was born, trading as "DIA". The DIA security trades at 1/100 of the DJIA and tracks it exactly.

You can even trade the S&P MidCap 400 index through the "MDY" tracking security.

What about the NASDAQ? The success of the Diamonds and Spiders naturally led the AMEX to set up a tracking stock for the NASDAQ 100 (which already trades on the option markets as NDX).

Originally, rumor had it that this tracker would trade simply as "Q" – just like James Bond’s faithful gadget builder. ("Do be careful with the exploding corkscrew, James!")

But the NASDAQ index security debuted earlier this year as "QQQ". The QQQ moves in sync with the leading NASDAQ components (by market cap weight) – MSFT, INTC, DELL, CSCO, WCOM and AMAT. Each "Q" share represents 1/20th of the NASDAQ 100 index.

Just like the Ginsu knife commercials, that’s not all! Yes, there is more. The AMEX decided to carve up the SPY into tasty, sector-size chunks through nine smaller Spiders. Each tracks one sector of the S&P 500.

The mini-Spiders are weighted by market cap like the NASDAQ tracker, QQQ. I suggest you look carefully at the stocks that make up the top 50% of each mini-Spider sector security. That gives you a good idea what you are getting into.

For example, the "XLK" security tracks 83 technology companies on the S&P500. But MSFT accounts for 16% of the total. Add the next six stocks to get the top 50%: INTC, CSCO, T, IBM, WCOM and AOL. Only four more - LU, DELL, HWP and EMC – brings you to 60%.

If you really want a representative spread of stocks instead of a few lumbering giants, you may want to look at a conventional mutual fund, or pick a basket of stocks on your own.

Some of the mini-Spiders also have deceptive names. The top one-third of the Cyclicals/Transportation tracker, "XLY", consists of WMT and HD, two large retailers. Throw in the fifth-largest stock, The Gap (GPS), and you have 37% of a tracker that represents 67 companies altogether. GM and F round out the top five. But the enormous success of retailers like WMT and HD have skewed the XLY weighting.

Maybe AMEX should call it the "Wal-Mart-Home Depot-and-a few-other-little-guys" tracking stock.

The mini-Spiders do have advantages. You know exactly what you are buying, unlike many mutual funds where the fund managers can buy or sell pretty much whatever they like within broad guidelines. A mini-Spider can only hold the S&P500 stocks that the AMEX designated for that sector.

Finally, don’t forget that you can buy WEB’s on the Web. WEBS stands for "World Equity Benchmark Series" tracking stocks. Each of the 17 WEBS tracks a different foreign stock index in Europe, Latin America and Asia. Like the Spiders, you buy a WEB just like any other stock.

As AMEX describes them:" Each WEBS series represents an investment in an optimized portfolio of publicly traded foreign stocks in a selected country. Each WEBS Index Series seeks to generate investment results that generally correspond to the price and yield performance of a specific Morgan Stanley Capital International (MSCI) index. MSCI Indices are leading country index benchmarks, widely used by U.S. investors for their international investments."

Once again you can save the high management fees associated with most mutual funds and still get international benchmark performance.

"Closed-end funds" offer similar ease of trading. Listed mostly on the New York Stock Exchange, these are securities which represent a basket of securities in a given sector or country, like the mini-Spiders and Webs. They are run by private investment firms, not the AMEX.

Run a symbol lookup at Yahoo for a subject like "France" and you turn up FRF, the France Growth Fund, a closed-end fund which, not surprisingly, invests in French companies. You also turn up EWQ, the WEBS tracker for France.