Don’t worry if you missed out on Facebook’s initial public offering. Chances are, if you own shares in a broad-based index fund, you’ll be holding onto some Facebook soon enough.
Facebook is such a huge offering -– with an initial market capitalization of more than $100 billion, it instantly becomes one of the 25 largest “cap” stocks — that it could have a distorting effect on some funds, at least in the short term.
“Clearly, they’re going to have to be buying a lot of it,” says Robert Jennings, a finance professor at Indiana University.
Index funds are a type of mutual find designed to mirror the returns of a stock market index. They add stocks to their lists in one of two ways: either through selection by a committee, as with the Standard & Poor’s 500, or based on certain rules, such as the size of a stock’s market capitalization.
Either way, a lot of those funds are going to be buying Facebook in the coming weeks. That could help the social networking company’s share price, if only temporarily.
When an index such as the Nasdaq 100, S&P 500 or Wilshire 5000 announces it is going to add a company to its list — usually after hours — speculators line up, knowing there will soon be a quick “pop” upward in the stock price as loads of mutual funds move to buy in.
“When stocks are added to the index, they’ve got to blindly go out and buy it,” at whatever price it’s trading at, says Allan Roth, founder of Wealth Logic, an investment advisory and financial planning firm in Colorado.
Because Facebook is now so big, it’s going to have a greater effect on index funds than a smaller company would. Indices are meant to track the stock market broadly, so sometimes limits are put on how much weight an individual stock can carry.
That’s already happened with Apple. The growth of its share price has been so rapid in recent years that some indices have taken steps to limit Apple’s weight within their listings.
The whole point of an index, after all, is to track the market or some large segment of it, not to ride the fortunes of an individual stock.
“The Nasdaq 100 is usually a market-cap weighted index, but finally they had to cap the percent that was Apple, because Apple was a third of the index,” says Jennings, who served on Nasdaq’s economic advisory board from 2002 to 2004.
Not all mutual funds will have that kind of circuit breaker, however. Some managed funds may be inclined to take more risks to reap higher returns, and that may include buying big stakes in hot stocks such as Facebook, Apple and Google.
Funds that don’t may come in for criticism from investors who feel they’re missing out. This dynamic is one reason why expert money managers can be as prone to following trends as individual investors — and why funds that shine one year can be beaten badly by index funds the next.
“Investors should be very worried that a managed fund will get too heavy into any one stock, and ‘hot’ stocks are especially worrisome,” says Roth of Wealth Logic. “Performance chasing does happen by professional mutual fund managers.”