How Facebook Will Sneak Into Your ETFs

It's the most closely watched initial public offering in a long, long time, and it surely will be one of the largest single IPOs in U.S. history.

What--you haven't heard that Facebook is going public?

As the insanely popular social-networking giant begins life as a public company on Friday, May 18 at an implied market capitalization of $93 billion to $104 billion, exchange-traded product investors may find themselves wondering what exchange-traded funds or exchange-traded notes will soon count Facebook as one of its holdings.

My colleague, Morningstar equity analyst Rick Summer, recently laid out his pre-IPO thoughts on Facebook's business model, concluding that the company's "social graph" indeed means that the company has a wide economic moat, which our equity analysts define as having sustainable competitive advantages. At the same time, Rick expressed concerns about Facebook's permanent lack of visibility into advertisers' return on investment for their ads on the site. He also highlighted the fact that the company's valuation is pretty full at its proposed offer price, trading at some 59 times the company's estimated 2012 earnings.

However, investors who see Facebook as undervalued and want to invest but also desire the protection of diversification can consider an ETF. So what is the best way for an ETF to gain exposure to Facebook?

What Kind of Company Is Facebook?
First, a word on classification. Investors should be aware of the investment world's general murkiness when it comes to categorizing Internet-oriented companies. Broadly, Internet companies are engaged either in Internet commerce (think Amazon.com AMZN, Priceline PCLN) or Internet services (for example, Google GOOG, Juniper Networks JNPR, and Yahoo YHOO). But Wall Street thus far has assigned some Internet companies to the consumer services or consumer cyclical industries, others to the media or business services realms, and still others to the specialty retail sector. What Wall Street seldom does, however, is lump all Internet companies into a single Internet "bucket," when it comes to coverage. Some niche investment products--notably, ETF First Trust Dow Jones Internet Index FDN--focus solely on Internet companies, but most do not.

We expect the investment community to lump Facebook in with Internet services companies like Google and Yahoo.

A Relatively Small Float Means Relatively Small Positions in Some ETFs
We have taken a close look at some ETFs and ETNs that we think would be most relevant for an investor seeking exposure to Facebook. In particular, we have studied their prospectuses to get a sense of what kind of position Facebook would occupy in these funds, and how soon before Facebook would appear as a holding. This is because most ETFs require a "seasoning period" for companies that have just gone public, meaning that Facebook won't necessarily be held in all of the below ETFs on its first day of trading.

What's more, despite an implied market cap of around $100 billion, Facebook likely will occupy a much smaller position in most ETFs (and mutual funds) than one might think. Why? The reason is that many index providers base their weightings of companies in their indexes (which ETFs and mutual funds often seek to replicate) on the total value of shares that investors can purchase on open markets. The theory behind such an adjustment, which is known as float-adjusted market-capitalization weighting, is simple: It's viewed as a better reflection of the actual market itself.

Facebook's float-adjusted market cap is expected to be somewhere between $10 billion and $14 billion, landing the company's size from a float-adjusted market-cap-weighted index perspective squarely in the mid-cap company range.

Even so, Facebook is expected to make up a decent chunk of assets in a broad variety of exchange-traded products. It's critical for investors to understand that although ordinary investors may find the first-day gain the most appealing part of an IPO, ETF and ETN investors have no chance of enjoying that gain. In every case, newly issued securities require a certain amount of trading activity before being added. Here is a quick look at some of the ETFs and ETNs expected to hold meaningful positions of Facebook, and when they will begin doing so:

Global X Social Media ETF SOCL
This is the lone ETF that focuses solely on social-media companies. It was launched last fall with an eye toward the future IPOs of firms such as Facebook and Twitter, and it already holds recently listed social-media companies such as Groupon GRPN, Zynga ZNGA, Yandex YNDX, LinkedIn LNKD, and Yelp YELP. Facebook is expected to be added very quickly to the Solactive-managed index that this ETF tracks. Under the index's rules, newly listed firms can be added to the index--and hence, to the ETF--after their fifth day of trading. That means that by Tuesday, May 29, Facebook should be a component of SOCL. This ETF's index takes into account a newly listed company's existing float, which means that Facebook's $9.5 billion to $12 billion float-adjusted market cap will determine its position size. That said, Facebook is expected to be one of the ETF's largest holdings with likely an 8% to 10% position size, and SOCL caps holdings at a 10% position size anyhow. SOCL charges 0.65%.

First Trust Dow Jones Internet Index FDN
This is a very liquid fund that holds 41 companies that generate at least half of their revenues from the Internet. We wouldn't expect to see Facebook in FDN for quite some time, however; the index that this fund attempts to replicate requires all constituents to have a minimum of three months' trading history. The index composition is reviewed each quarter, and rebalancing occurs after the close of trading on the third Friday of September, which likely will be when Facebook is added to this index and this ETF. And when Facebook is added, its float-adjusted market cap will ensure that its stake remains relatively small; assuming that in September, the company is trading around its offer price range (not necessarily the safest assumption in the world), Facebook would make up between 3% and 4% of FDN. FDN charges 0.60%.

First Trust US IPO Index FPX
A fairly thinly traded fund, FPX replicates an index of the 100 largest and most liquid companies that have gone public in the last 1,000 days. Companies do not join the index until seven days after they begin trading, which means Facebook would join FPX in late May. FPX's portfolio is market-cap-weighted, and a holding's position is not based on its float-adjusted market cap but rather on its total market cap. That means that Facebook likely will be a top holding in this fund. However, holdings are capped at 10%, however, meaning that Facebook likely will make up the full 10% of FPX. The ETF charges 0.60%.

PowerShares QQQ QQQ
A wide variety of investment products tracks the NASDAQ-100 Index, which is a benchmark consisting of the 100 largest nonfinancial firms trading on the Nasdaq exchange. The best-known and most liquid is the behemoth PowerShares QQQ, also known as the Cubes. Just a few weeks ago, Nasdaq OMX altered the rules for three of its indexes, including the NASDAQ-100, regarding how long companies needed to be public before joining the indexes. Previously, Nasdaq had required at least a year of life as a public company before being eligible for inclusion. Now, that period has been shortened to between three and four months. That means that Facebook should enter the Nasdaq-100 Index at the time of its annual rebalance in December, and it should as a result join PowerShares QQQ and other NASDAQ-100 Index-related investment products at that time as well. In addition, some arcane aspects of Facebook's offering mean that the company has both A and B shares, with only its A shares going public. As a result, for the Nasdaq's purposes, Facebook's market cap effectively will be its float-adjusted market cap, which as noted above will be somewhere in the range of $10 billion to $14 billion. That would give Facebook a weight of a paltry 0.3% to 0.4% in the Cubes, making its position size utterly insignificant when compared to say, the 18%-plus weight that Apple AAPL occupies. There also are other ETFs based on components of the NASDAQ-100 Index, including the equally weighted First Trust NASDAQ-100-Technology Sector Index Fund QTEC. That ETF, which charges 0.60%, holds 43 companies. Although QTEC rebalances four times a year, it reconstitutes in December, based on the NASDAQ-100's reconstitution each December. As a result, Facebook likely would be added to QTEC in December 2012. At that time, Facebook (assuming it is trading in its offer price range) likely would make up between 2% and 3% of QTEC's portfolio.

PowerShares NASDAQ Internet Portfolio PNQI
The same Nasdaq rules that, if unchanged, would restrict Facebook to a small position in the Cubes also would limit Facebook's position in this ETF, which tracks a NASDAQ-managed index of U.S.-listed Internet companies. However, because of the largely smaller-cap tilt of this ETF, Facebook stands to make up a slightly larger portion of its portfolio when it is added, likely at the time of its index's next annual evaluation, which will be in March 2013. At that time, Facebook (assuming a share price in the offer price range) would comprise perhaps 4% to 5% of PNQI. The ETF charges 0.60% and holds 69 companies.

UBS ETRACS Next Generation Internet ETN EIPO
This thinly traded ETN nearly perfectly tracks a UBS-sponsored, Standard & Poor's-calculated index of Internet companies listed on the NYSE and the Nasdaq that have been publicly traded for three years or less. The index calculates an issuer's market cap based on the combined market cap of all its share classes, regardless of whether shares are held by insiders or related shareholders, which means that the index will consider Facebook's total market cap of around $100 billion. The ETN also caps constituents at 10% of the index. Finally, the index is rebalanced monthly at the close of business on the first Tuesday of every month. That would suggest that Facebook would join the index--and then as a result, begin influencing the ETN's performance--on Tuesday, June 5. (UBS also has the right to adjust the index's composition on an intra-month basis for "extraordinary events" that in the judgment of S&P, but that provision seems more designed for deletions from the index, rather than inclusions.) As such, we would expect Facebook to make up 10% of EIPO's index. EIPO charges an annual tracking fee of 0.65%.