When Will Your Index Fund Buy Facebook Stock?

Facebook will have an IPO soon. If you invest through mutual funds, will those mutual funds buy Facebook stock after the IPO? If so, when will they buy it?

People ask this question because either they worry their mutual funds will buy into a bubble and pay a price too high or they worry their mutual funds will miss out on Facebook for too long.

In actively managed funds, it’s completely up to the discretion of the fund manager(s). When you pay a higher management fee to actively managed funds, you are paying for such discretion. Whether the fund manager’s decision to buy or not buy or buy at what price determines whether your funds will do better or worse than the market.

What about index funds? Index funds follow an index. It depends on how soon the index provider will include Facebook in the index. If the index adds Facebook, all index funds following that index will add Facebook as well, not necessarily all on the same day but they will sooner or later.

Over at Crawling Road blog, Craig looked at the inclusion policies of a few different index providers. S&P requires an aging period of 6-12 months after the IPO. It also wants to see some consecutive quarters of positive earnings. Other index providers warm up to IPOs sooner. Russell looks at IPO stocks quarterly. Wilshire does it monthly.

It’s also helpful to look at the history and see when mutual funds added Google, to which Facebook’s IPO is often compared.

Google had its IPO in August 2004. The closing price on the first day of trading was about $100 a share. S&P 500 didn’t add Google until 20 months later in March 2006, when the price was already $360 a share. The early run-up was over. As I’m writing this, Google trades at about $600 a share. S&P’s slow action means investors in S&P 500 funds missed some gains.

A total stock market fund will add a new stock sooner. By the end of September 2004, merely one month after its IPO, Google already appeared in the holdings of Vanguard Total Stock Market Index Fund. The price at that time was about $130 a share. The fund probably bought Google at a price lower than that. By including Google sooner, a total stock market fund gave investors the early gains in Google.

History suggests that a total stock market fund will add Facebook sooner than a S&P 500 fund. Whether sooner this time means a boon or a curse depends on whether Facebook will be like Google. When Google came out, there were also a lot of party poopers saying how vastly overvalued it was. It turned out the best time to buy Google stock was when it first came out.

However, if you step back a little you will see all this doesn’t really matter. When Vanguard Total Stock Market Index Fund included Google as of September 2004, Google made up of only 0.24% of the fund’s assets. Even though Google tripled by the time a S&P 500 fund added it in March 2006, we are still talking about a stock that was less than 1% in the fund.

This time, whether an index fund pays too much or gets a bargain price for Facebook stock, it’s not going to materially affect the fund’s performance one way or the other. To really make money or lose money, a fund has to buy a lot of Facebook shares. It’s just not going to happen in a highly diversified total stock market or S&P 500 fund. As large as Facebook is, the market is much much larger.