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.
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