It’s hard to find friends of Facebook’s Initial Public Offering [1] (IPO [2]). Commentators are lining up to poke the social network’s prospects with a stick, and most aren’t hitting the like button.
From Reuters [3]:
Here’s the thing about the big, honking 187-page prospectus Facebook filed late Wednesday. Once you dig past those headline numbers, the company itself ends up looking pretty unremarkable.
From Wall Street analysts [4]:
Retired Neuberger Berman value investor and present CNBC commentator Gary Kaminsky observed that at similar multiples as Facebook, Google would be trading at $850 and Apple trading at $1250.
From CBS News [5]:
At $5 per customer, Facebook is really bad at making money off its customer base.
And so on. Wearing my passive investor’s [6] Helm of Much Smugness, I let the furore rage over my head. Whatever will be, will be – let the index decide.
But wait!
Facebook is going to be worth billions. It’s the pump primer for the tech bubble part II [7]. Am I predestined to scoop up tons of the stuff as my tracker robotically swings into action, like an ASIMO sent to clean up a nuclear accident?
Most index trackers [8] hold securities in proportion to their presence in the index that is followed by the fund. Give or take a few quirks in replication strategies it’s a financial game of Simon Says.
But what happens when an index tracker has to deal with big new IPOs [9]?
Your exposure to Facebook
Any passive investor with a globally diversified portfolio [10] is likely to hold an index tracker that covers the US market. How big a splashdown Facebook makes in your world will depend on:
- What index [11] your tracker tracks.
- How the index admits new entrants.
- The size of the index.
- Your portfolio’s size and exposure to that tracker.
- Facebook’s market cap.1 [12]
So how much Facebook action would a regular 60:40 equity/bond portfolio get, in raw moolah terms?
Here’s one possible calculation, assuming:
- Portfolio size = $100,000
- US equity allocation of 50% = 30% of a 60:40 portfolio
- Facebook’s market cap = $100 billion = 0.5% of index being tracked
Then:
(Portfolio size) x (US equity exposure) x (index exposure) = Facebook held
Substituting in:
$100,000 x 0.3 x 0.005 = $1502 [13]
That’s equivalent to 0.15% of our notional $100,000 portfolio. I reckon I can stand that kind of punt on one of the planet’s best known brands.
Signing up
Facebook (Ticker: FB) won’t hit the New York Stock Exchange (NYSE) or NASDAQ for another three to four months.
Even then it’s not going to instantly pop into your index tracker in a puff of hype.
The indices will take some time to grind into action and admit Facebook into the ranks. How that affects you depends, as mentioned above, on the index you track and its rules on new members.
UK passive investors may well get their US exposure from one of the following:
| Index tracker | Index it replicates |
| HSBC American Index Fund | S&P 500 |
| Vanguard US Index Fund | S&P Total Market Index |
| iShares MSCI World ETF | MSCI World |
| Vanguard FTSE Developed World ex-U.K. | FTSE Developed ex UK Index |
Each index has its own brand method of carving up the investable US market.
Facebook’s impact upon a global index like MSCI World will be diluted by the fact that this benchmark monitors an investible universe worth $22.5 billion.
Facebook’s influence will be around twice as large in the well-known S&P 500 index that concentrates on US large cap companies worth over $11 billion.
Platinum membership: The S&P 500
If your index tracker follows the S&P 500, then you may well have to wait a while before you own a piece of Facebook. Google went public on August 25, 2004 but it didn’t gain entry to the S&P 500 until March 31, 2006.
Facebook only needs a market cap of $5 billion to get into the S&P 500, which is much less than its currently guesstimated valuation of $80-100 billion. But size alone is no passport to entry.
S&P 500 companies must also have a public float of 50%. That means half of the company’s shares must be tradable on a public exchange.
It’s thought only 5% of Facebook’s shares will be made publically available through the IPO. The rest will be controlled by management, employees, and early investors. Most are subject to various lock-ups [14].
Even when enough Facebook paper millionaires/billionaires cash out and start building rocket ships to Alpha Centauri, the final decision on entry is made by the S&P index selection committee. Its members stuff their pipe with a company’s financials, liquidity, and trading volume numbers, smoke it, and then make an announcement if the company gets in.
And even if a company has all the right chops, its industry sector mustn’t be over-subscribed and an existing member must be fit for elimination.
It all reminds me of the time I tried to get into the Gentleman’s Beefsteak Club.
Tufty Club membership: The S&P TMIX
In contrast, Facebook’s entry into the Vanguard US Equity Index fund is likely to be far swifter, because getting into its S&P Total Market Index (S&P TMIX) is about as tough as getting through the doors at McDonald’s.
The S&P TMIX offers exposure to large, mid, small, and micro cap companies that trade on the NYSE and NASDAQ.
In this case there is no:
- Minimum market cap
- Worries about the public float
- Bother with financial viability nonsense
The index is rebalanced quarterly, so it will only be a matter of weeks after Facebook’s IPO before it will be ushered into the S&P TMIX.
Facebook could be a relative lightweight
The weighting of Facebook in the indices may not match the heady $100 billion valuation being put on the company by the media, however.
Most indices – including the S&P 500 and S&P TMIX – calculate a company’s market cap using what is known as a ‘free-float methodology’.
The company’s share price is multiplied by the number of shares freely available in the market to determine its free-float market cap. It excludes shares sat on by company insiders, other public companies, and governments.
If only 5% of Facebook’s outstanding shares are made publicly available, then the impact on index trackers governed by the free-float methodology will be a fraction of the valuations hitting the headlines now.
Market impact costs
The mechanical responses of trackers to index changes make them easy pickings for hedge fund sharps and arbitrage bandits.
They lie in wait knowing exactly when a fat caravan of index trackers is coming down the road to buy and sell.
The arbitrageurs nip in first, driving up the prices of securities that the trackers must buy.
Worse, the tracker funds will have to sell the securities kicked out of the index (which the arbitrageurs have been furiously selling) and so they earn depressed prices on exit and pay inflated prices on entry.
When Berkshire Hathaway entered the S&P 500 in 2010, the price of its shares jumped almost 12% between the S&P’s announcement and the couple of weeks it took for the index trackers to make their move.
This index turnover cost is calculated by New York University Professor Antti Petajisto [15] to equate to a drag on performance of 0.21-0.28% a year, between 1990 and 2005.
This isn’t a cost that would show up on any fee schedule, but would stealthily chip away at returns through tracking error [16]. (Of course, a great many active funds are closet trackers enrobed in high fees, and so they suffer the same malaise).
You can avoid this problem with a synthetic ETF – mostly because it’s unlikely to hold any shares in the companies it notionally tracks – but then it may well be stuffed with Japanese small-caps, so you really need to know what you’re jumping into bed [17] with.
Poke me, I must be dreaming
Of course, we’ll all be smiling if Facebook turns into the next Google.
And even if it doesn’t, the ponderous reflexes of index trackers will at least help passive investors avoid a Day One bloody nose if the internet giant, like so many IPOs [18], dives like a paper dart.
Take it steady,
The Accumulator