ETFs Skip The Facebook Froth
May 30, 2012
Investors in broad index ETFs have a few things to crow about.
Facebook’s flubbed launched has become a lightning rod for all that’s wrong with U.S. equity markets.
But let’s not forget that the simple and sane rules that govern most broad U.S. indexes—and therefore the ETFs that track them—protected many investors from the hoopla surrounding Facebook’s botched initial public offering.
While some niche ETFs do have Facebook exposure, as my colleague Alex Ulam noted recently, none of the big and broad index-based ETFs holds Facebook yet.
That’s because broad indexes like the S&P 500 and the Russell 1000 require a seasoning period for new issues prior to admission to the index.
Even the Nasdaq-100, tracked by PowerShares QQQ Trust (NasdaqGM: QQQ), which shortened the waiting period in advance of the Facebook IPO, has more than three months to go before the stock is eligible, as my colleague Carolyn Hill said last month.
Facebook provides a case in point as to why this evaluation period for new issues makes sense.
We’ve all witnessed some unsavory aspects of investment banks’ behind-the-scenes sausage-making on this particular IPO: selective disclosure of research, and propping up the stock with one hand while lending shares for shorting with the other. The fact that both of these practices are legal provides less comfort, not more.
Beyond this, the rationale for a cooling-off period for less splashy IPOs than Facebook’s makes sense too—namely that a new issue needs some time to establish liquidity and bear the public scrutiny from analysts and the market as a whole.
After all, price is a huge component of cap-weighted indexes, so getting the price-setting benefit of all market participants over a reasonable length of time makes sense before the ETF takes a position.
This holds true in spades for a big IPO like Facebook, where a fund will eventually take a huge position in the stock all at once.
The key point for index investors is that when Facebook finds its way into the broad indexes, it will be priced downstream from all this initial turbulence.
Equally important, Facebook’s place within broad indexes will likely be substantial but not dominant due to the diversified nature of broad indexes.
Facebook also highlights another advantage of index investing using ETFs: transparency.
Almost all passive ETF issuers publish daily holdings, so investors can see what’s in the portfolio. Even investors in passive index mutual fund investors lack this advantage.
In an active mutual fund, the presence or absence of Facebook in the list of holdings could just be window dressing rather than truly reflecting the portfolio’s position throughout the quarter.
But active ETFs, on the other hand, are required to reveal positions daily.
I have no idea what the right price for Facebook is, and based on the stock’s volatility over the first week of trading, it seems I’m not alone in wondering what the company is worth.
The point is that boring-old index-tracking ETFs protected investors from the worst of this froth.
In this sense, the father of index investing, Jack Bogle, and rap legend Flavor Flav share a common credo: Don’t believe the hype.