Whether you love them or hate them, index funds have become some of the most popular investing tools ever. But by definition, index funds rely on the indexes that they track -- and with the most popular indexes having billions or even trillions of dollars tracking them, it's a noteworthy event whenever an index makes major changes.
Last week, I looked at changes that Standard & Poor's made to its well-known S&P 500 benchmark, as well as its lesser-known mid-cap and small-cap indexes. Stocks like Regeneron Pharmaceuticals (NAS: REGN) and Perrigo (NAS: PRGO) did indeed see some unusual volatility during the last hour of trading on Friday, as index funds scurried to match up their holdings to the benchmark.
But another set of index additions also took effect at the close of business on Friday. Those additions affect a much different class of stocks than the S&P changes, but over the long haul, they could have a much more significant impact on the companies involved.
Russell adds the IPOs
Russell Investments isn't quite as much a household name as the Dow or S&P, but it's an index powerhouse in the industry. With $3.9 trillion in assets using Russell indexes as benchmarks globally, the company has a lot of influence.
Last week, Russell made its quarterly announcement about adding companies that recently made their initial public offerings to its indexes. Among the companies that are now part of the Russell 2000 small-cap indexes are InvenSense (NYS: INVN) and Angie's List. Groupon (NAS: GRPN) bypassed the Russell 2000 entirely, instead going into the large-cap Russell 1000 index.
Groupon saw a big spike near the close last Friday, undoubtedly related to the Russell move. For the most part, though, the other companies involved didn't see huge jump as a result of their additions. What these companies should count on, though, is greater visibility -- and higher share liquidity over time.
Why indexes are essential
Getting added to major indexes plays a vital role for new companies. Especially with float-adjusted indexes, being a member essentially ensures funding for future rounds of secondary offerings.
This happens more often than you might think. With several IPOs over the past couple years, including Molycorp (NYS: MCP) , Tesla Motors (NAS: TSLA) , and Motricity (NAS: MOTR) , small initial floats built up demand. Yet then when lockup periods expired, insiders were able to sell their own personal holdings into the market. If an index then boosts its weighting to reflect the newly available shares, then index funds have to add even more money to their existing holdings -- regardless of price.
Don't be a trader
As far as short-term moves are concerned, it's too late to capitalize on any short-term bump that may have occurred in connection to the Russell moves. With the stocks officially added to the indexes today, index funds made their moves before the close on Friday.
Moreover, it's hard to draw conclusions about the performance of newly added stocks in the longer run. For the most part, you can expect that the companies that got added to the Russell indexes will likely trade on their own merits rather than getting some magical boost from their membership.
But perhaps the most important thing to realize is that if you own index funds that track these indexes, you now own shares of these IPOs indirectly -- even if you would otherwise have no interest whatsoever in buying them yourself as individual holdings in your own portfolio. As a handful among thousands of stocks, the impact will likely be minimal to your returns -- but it's still there. And if you think that these stocks are largely flash-in-the-pan businesses that will eventually fail, then you probably won't be excited to see them among your Russell index holdings going forward.
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At the time thisarticle was published Fool contributor Dan Caplinger isn't thrilled about owning these stocks in his index funds. You can follow him on Twitter here. He doesn't directly own shares of the companies mentioned in this article. The Motley Fool owns shares of InvenSense. Motley Fool newsletter services have recommended buying shares of Tesla Motors. 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 sells you short.
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