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Many smart investors are dubious about whether Facebook deserves anything close to the $100 billion valuation that some are projecting for the social media giant. But if you own an index fund, the odds are strong that sooner or later, you're going to end up owning shares -- and you might well end up paying a pretty penny for them.

The pluses and minuses of index funds
Index funds are one of the most efficient ways to invest in the overall market. By giving you a small portion of hundreds of different stocks, they virtually eliminate stock-specific risk in your portfolio, instead tracking the broader market. Moreover, compared to traditional mutual funds, the expenses on index funds are next to nothing, making it both easy and cheap to invest using index trackers.

But the downside of index funds comes from their mechanical behavior. When a new company becomes eligible for whatever index a particular fund tracks, then the fund has no choice: It has to go out into the market and buy up shares, no matter what the cost. If Facebook comes to market with anything close to that $100 billion market-cap estimate, then it's just a matter of time before the company shows up in the S&P 500 -- where trillions of investor dollars will have to chase shares.

Facebook: Not the first, won't be the last
Of course, the S&P 500 has had to grab hot stocks before. Overall, it's had a somewhat mixed record. In the late 1990s, it had the terrible misfortune of bringing in a number of tech and Internet stocks, including Yahoo! and Broadvision, into the index at just about the worst possible time: immediately before the tech bust pulled those shares back down to earth. In the mid 2000s, the index did the same thing with soaring homebuilder stocks D.R. Horton and Lennar, as well as the mortgage-loan maker and discount broker E*TRADE Financial (Nasdaq: ETFC  ) -- each of which plummeted in the ensuing years.

But among some more recent additions, the index hasn't done quite as badly. Let's take a look at some examples:

Google (Nasdaq: GOOG  ) , added March 31, 2006
The search giant came into the S&P 500 at $390 per share. That may not seem like much compared to its current levels above $600, but at the time, many saw it as a travesty. After all, the shares had come public for less than $100 just a year and a half earlier.

Overall, however, investors haven't had a lot to complain about with Google. The shares almost doubled from their S&P entry level by late 2007 before plunging in the market meltdown, and with better than a 50% gain, the shares have outperformed the broader index.

Amazon.com (Nasdaq: AMZN  ) , added Nov. 18, 2005
Unlike Google, the king of online retail had to wait a long time after its IPO to join the S&P. Only after surviving its descent to single-digit share prices did Amazon make the grade, finding itself added to the index at just shy of $48 per share.

That figure looked widely overpriced over the following year, as the stock lost close to half its value. But by October 2007, the stock had doubled from its S&P addition price, and its four-bagger at current levels hasn't disappointed anyone.

priceline.com (Nasdaq: PCLN  ) , added Nov. 3, 2009
Another revived Internet play from the late 1990s, Priceline seemed like a ridiculous addition in late 2009, after the stock had not only recovered from the market meltdown but eclipsed its pre-meltdown highs by a substantial amount.

Yet less than a week after it had been added, Priceline announced strong earnings, and the shares have never looked back. Since then, the company has more than tripled in price, soaring as it clearly won the battle of the online travel portals. Trading at 18 times 2012 earnings estimates, the company may still have more room to run if it continues to grow at its recent pace.

Netflix (Nasdaq: NFLX  ) , added Dec. 17, 2010
The online streaming company has had a more sobering performance since its entry into the S&P 500 a bit more than a year ago. Coming into the index at about $180 per share, the stock climbed above $300 before crashing down into the $60s. At current levels, the shares have still lost more than 30%.

Whether Netflix will prove to be a long-term disaster for the S&P 500 or just a temporary setback remains to be seen. But with the stock having risen tenfold since its late 2008 lows, Netflix wasn't a popular addition for every index investor.

Grin and bear it
For good or bad, if you're going to accept investing in index funds, you have to be willing to put up with the mistakes that index managers make. Although it can cost you some of your returns, it's part of the price you pay for the convenience that index funds give you.

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Fool contributor Dan Caplinger knows his broad market index funds will end up buying Facebook a lot sooner than the S&P 500 does. 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 Google, Amazon.com, and Yahoo!. Motley Fool newsletter services have recommended buying shares of Google, Netflix, priceline.com, Amazon.com, and Yahoo!. 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 knows what privacy is.


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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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