Does Your ETF Own Facebook?

For all the stock market’s current woes, the initial public offering for Facebook (FB) created plenty of excitement this month.

Unfortunately, some of it was the wrong kind of excitement. Now the company must deal with investors unhappy at aggressive pricing and system glitches. But that’s not my subject today.

Instead, I want to take a look at how ETFs are — or will be — involved in Facebook and other IPOs.

Is Your ETF Part of
the Facebook Action?

The vast majority of ETFs are tied to an index whose holdings are determined by an unrelated provider. The index provider, in turn, must follow pre-defined rules when adding (or removing) stocks from the index. They must also announce changes to the index in advance.

An ETF manager may have a little bit of wiggle room in matching its actual portfolio to the chosen index … but they can’t stray too far.

To me, this is one of the prime attractions. Actively-managed products like mutual funds frequently keep their current holdings list secret. With indexed ETFs, you know ahead of time exactly what you’re getting.

Mutual funds keep their portfolio moves confidential.

One consequence, however, is that ETFs are typically prevented from holding new companies like Facebook … until the company is added to the underlying index.

How long does this take? It depends on the rules of each particular index. In most cases, the provider reviews index holdings quarterly or annually. Any new stocks that are otherwise qualified (meaning they are in the right sector, have adequate liquidity, etc) will join the index at the next such “reconstitution” date.

Any ETFs tracking an index generally adjust their portfolio at the same time the index holdings change. This all happens behind the scenes whether you like it or not.

Index providers will begin adding Facebook as they perform their regular reviews. Given its substantial size, I expect we will see FB included in nearly every broad-market, large-cap blend, large-cap growth, and technology index within months. By my count, more than 115 of today’s ETFs and ETNs will eventually include Facebook.

Some Indexes Just Can’t Wait

A few index and ETF providers can move faster. They don’t have to wait because their rules anticipated situations like this.

Global X Social Media (SOCL) added Facebook to its holdings with an 8.8 percent weighting on May 23, just a week after the IPO. This makes perfect sense. You can’t have a “social media” ETF without the largest social media stock.

Some ETFs want Facebook now.

As far as I know, SOCL is the only ETF to hold Facebook so far. Some other specialized products are not far behind. ETRACS Next Generation Internet ETN (EIPO) and ETRACS 2X Next Generation Internet ETN (EIPL) both follow an index that will likely include Facebook within weeks.

SOCL, EIPO, and EIPL are small potatoes next to another index that will soon include Facebook. The Nasdaq 100 is the underlying index behind the massive PowerShares QQQ ETF.

The QQQ index provider is speeding up its normal schedule and will probably add FB after three months. Facebook will likely have a relatively small weighting in the index and QQQ. But it will be there.

Do You Want Facebook
in Your ETF?

Now that we know how this works, let’s ask a more fundamental question. If Facebook shows up in the holdings of an ETF you own, is it helpful or not?

The answer depends on how Facebook shares perform, of course. Ditto for any other individual stock. We don’t know yet. And frankly, I wouldn’t worry too much about it either way.

Remember, the whole point of an ETF is to diversify among companies in a market segment — large cap, technology, etc. As long as the weightings are reasonable, you probably shouldn’t dwell on whether any single stock is included or not.

Sometimes the weightings aren’t reasonable, as I recently pointed out for General Electric (GE) and “Industrial” sector ETFs. I don’t anticipate Facebook will dominate the tech sector.

I will note, however, that my friend Mark Hulbert calculated in a recent column that Facebook shares would be fairly priced at around $13.80. That’s far below where it is now.

If Facebook shares keep falling the next few months but eventually recover, ETF investors may be glad they missed this IPO. The delays I described above allowed them to get in at a better price. We’ll have to wait and see.

Best wishes,

Ron

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