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Facebook addition not ideal for S&P 500 investors

S&P Dow Jones Indices announced after the market close Wednesday that Facebook was being added to the S&P 500 index. That's bad news for investors in these massive index funds.

As is typically the case, Facebook (FB) stock rose more than four percent in after-hours trading immediately following the news release. Why? Because traders know that the colossal S&P 500 index funds must go out and buy the stock when it is added to the index on Dec. 20. 

The two largest ETFs are now S&P 500 index funds and all share classes of Vanguard's S&P 500 funds are even larger. By my calculations, Vanguard's S&P 500 index fund must soon go out and buy approximately $1.2 billion of Facebook stock, making it the 23rd largest holding. Other large S&P 500 funds must do the same. 

While no one knows how Facebook stock will perform in the next year, there appears to be conclusive evidence that all of these funds are buying at an inflated price, bid up by traders who are well aware of the imperative for these funds to buy the stock.

The solution, of course, is to own a total stock index fund not subject to any committee selecting new stocks.  Examples are the Vanguard Total Stock Index Fund (VTI) and Schwab Broad Market Index Fund (SCHB), in which Facebook was already included in the index.

For those (like me) that own S&P 500 index funds but don't want to pay capital gains taxes to sell, there is also an easy solution. A completion index fund, known as the Extended Market Index fund, owns virtually every U.S. stock that is not in the S&P 500. Owning roughly 80 percent S&P 500 and 20 percent extended market index fund approximates the total market and immunizes investors from buying the overpriced new entrant. In this case, the extended market index fund must now sell Facebook as the S&P 500 must simultaneously buy it back.

Examples of extended market index funds include the Fidelity Spartan Extended Market Index Fund (FSEMX) or the Vanguard Extended Market ETF (VXF). 

It's ironic that the success of S&P 500 index funds, with hundreds of billions in assets, has now led to its disadvantage. There are other reasons S&P 500 index funds are unlikely to keep up with the market and there is a substantial case against owning S&P 500 index funds. Owning the entire market is the superior choice.

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