Index funds and ETFs not only simplify investing for millions of investors; they also are among the most efficient investments you can buy. But every so often, index funds have to do some dumb things -- and attentive investors can reap big profits from their need to follow an open rulebook.
Beating the index
One of the most popular ways investors take advantage of index funds is when the underlying index replaces one of its constituent stocks. Index funds have huge amounts of money tied up tracking popular indexes like the S&P 500, so when an index switches companies in and out, they're essentially forced to make big sales of the removed stock and massive buys of the added stock. Smart investors see the opportunity to get into a stock before those index funds have to pull the trigger.
Since everyone knows about constituent replacement, it's hard to cash in on the strategy. But some more subtle index-related moves aren't as well-known, and they may still have some profit potential.
Hello, Big Softy
One example comes from the way in which Standard & Poor's calculates its S&P 500 index. As a blog post in Barron's discussed earlier this week, the S&P 500 is a float-weighted index, which means that rather than looking at a company's total market cap to determine its weighting within the index, you have to omit shares owned by insiders and other shares that aren't available for trading by the general public. However, that rule no longer applies once insider-held shares fall below 10% -- at that point, the index simply uses the total market cap.
As the post describes, Microsoft (NAS: MSFT) is nearing that all-important 10% level. With co-founder Bill Gates having consistently sold off substantial parts of his Microsoft holdings to finance his charitable endeavors, Barron's estimates that the company could hit the 10% mark by early next year. And when that happens, index funds will have to boost their holdings of the stock -- creating huge buying pressure on Microsoft shares.
Thank you, sir, may I have another?
So with that trick in mind, I got curious about what other stocks might be in similar situations to Microsoft. Doing a quick screen for S&P 500 stocks with insider holdings just above the 10% mark gave me the following companies:
Current Insider Holding %
DeVry (NYS: DV)
Jabil Circuit (NYS: JBL)
Hasbro (NAS: HAS)
Airgas (NYS: ARG)
Paychex (NAS: PAYX)
Source: S&P Capital IQ.
It wouldn't take very much insider selling in any of these names to bring overall insider holdings below 10%, triggering the special float-adjustment rule that would require index funds to increase their positions in the stocks.
But before you assume that you should go out and buy all these stocks today in anticipation of such a move, keep in mind several important caveats:
None of these stocks has a market cap that comes anywhere near Microsoft's. Therefore, although the buying pressure may be proportionally similar, the sheer amount of money involved with these stocks would be far less.
Unlike with Microsoft, there's no immediate reason to believe that insiders will sell enough shares to reduce overall holdings below the 10% threshold.
Other factors can also have an impact on float. For instance, share buybacks can increase insider percentages without an insider ever having to buy a share. At the same time, though, options awards can decrease those percentages automatically as well.
In addition, the same thing could technically happen in reverse. For instance, at 9.23% insider ownership, Fastenal (NAS: FAST) isn't that far from going over the 10% threshold. Under the right circumstances, a reduction in float could force S&P 500-tracking index funds to sell shares.
Keep your eyes open
None of this makes index funds any less efficient for beginning and sophisticated investors alike. But for those who like to pick low-hanging fruit when it's available, knowing the ins and outs of how indexes work can reveal some interesting opportunities from time to time.
Meanwhile, Microsoft has bigger worries than having its shares bought by index funds. This free video from The Motley Fool reveals the two words Bill Gates doesn't want to hear -- or at least not until he sells off all his insider holdings.
At the time thisarticle was published Fool contributor Dan Caplinger was appalled when Vanilla Ice blatantly stole the riff from Queen and David Bowie's "Under Pressure." You can follow him on Twitter here. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Microsoft. Motley Fool newsletter services have recommended buying shares of Microsoft, Hasbro, and Paychex, as well as creating a bull call spread position in Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy never pressures you.
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