Will the SpaceX IPO Blow Up Your 401k?
If you have an index fund in your 401k, you may end up owing SpaceX. So what does that mean. Does index investing make sense, or will it produce some crazy result?
A good friend of mine told me about a video he just saw that had gotten him worried. The basic premise of the video was that 401ks were going to suck up new SpaceX shares at crazy inflated prices. “Who’s going to buy SpaceX at crazy prices? You will!” it says, more or less. The video goes on to say that SpaceX will be added to the NASDAQ 100 index right away after its IPO, and lots of 401ks are invested in indexes. If SpaceX gets added to the index, that means that 401k owners are going to be stuck buying the stock at whatever crazy price it goes public. And there are two more huge IPOs coming this year that are going to repeat the problem, Anthropic and OpenAI. Those will be two more huge market cap stocks that will need to be added to indexes and end up in 401ks.
My friend was, naturally, worried about his 401k getting ruined by a huge investment in SpaceX at overinflated prices, and that led to a discussion about indexes and index investing and generally how average people who are not investment experts can hope to manage their retirement funds when things like this happen.
The video is not completely wrong, but it leaves out a lot of important nuance. Like the fact that many 401ks are invested not in the NASDAQ 100 index, but in the S&P 500 index. Those are different indexes, with different rules and allocations. SpaceX stock will be added to the S&P 500 index eventually, but not for six months. By that time the initial volatility of the IPO should have shaken out somewhat.
There are hundreds of indexes, and there could be dozens of funds that track any individual index, and any individual stock could be in lots of different indexes. Google’s Gemini tells me that an index “fundamentally means a guide, pointer, or systematic measure used to reference or track information. Derived from Latin, the word original meant ‘one who points out’ or ‘forefinger’… A financial index tracks the price performance of a specific group of assets, such as stocks or bonds.” So an stock index is just a collection of stocks that have something in common.
There are countless stock indexes out there. There is the S&P 500 index, and the NASDAQ 100 index. There is the Russell 1,000, and the S&P SmallCap 600, and the Dow Jones Global Titans 50, just to name a few.
The S&P 500 is one of the best-known indexes. A committee decides which stocks are included in the index, but the general criteria is that they should mostly be the largest companies (measured in market cap) that trade on the New York Stock Exchange or NASDAQ. The index components don’t change very often, but if a company shrinks or goes out of business it is removed and replaced with another company. And if a company outside the index becomes big enough to meet the criteria, it can be added by removing a company that has become less relevant.
Historically, companies that are just going public are not large enough to include in the index. The rule for the S&P 500 has been that a company has to have been public for a year before it can be added to the index. The SpaceX IPO will be gigantic. The market cap of SpaceX will certainly be larger than many of the companies now in the index. Based on size alone, it will belong in the index. If it cannot be added for a year, the S&P 500 index will actually be somewhat distorted by not including it.
On the other hand, you might not want to add a new stock to an index immediately at its IPO because stock prices can be wild during an IPO. The company decides a price to bring the stock public with, but it’s the market that decides what it’s really worth. For some time after an IPO the price could either soar to the moon or completely tank.
So it’s a quandary how to handle a huge IPO like this. A decision has been made to allow SpaceX into the S&P 500 index after six months instead of waiting a full a year.
Other indexes will make different decisions. The NASDAQ 100 index will include SpaceX after only 15 days. Other indexes may include it immediately, or wait even more than six months.
Is this something 401k owners should be worried about? I think not. If SpaceX holds its value after the IPO, it truly does belong in the index. If it does not, it may not get added.
That leads to the related question. Does it make sense to invest your 401k in an index fund? I have been reading a number of articles recently stating that it may be time to go back to “active management” funds.
There are several difference between index funds and active management funds to be aware of. Active management funds are funds (or ETFs) where an individual or a committee decide on specific stocks to buy and sell. They could buy a stock one day and sell it the next if they have a reason to. They study the companies, and the good funds have some well-thought-out thesis for what constitutes a stock they think is worth investing in. If something they owns no longer fits the thesis, they sell it. If some new stock fits it, they buy it. Obviously all this buying and selling and research takes a lot of time. Somebody has to pay the salaries and other costs of doing it. They get paid for it by charging fees and expenses. The justification for doing it is that they can get returns doing this that are better, even after paying all the extra expenses, than an index fund would have gotten. The reality is that some funds actually can achieve that and others will not. And there’s no way to know for sure ahead of time which way it will go. You can look at their track record, but that doesn’t provide any guarantee of what their performance will be in the future. You generally measure them against the indexes. They beat the index returns, or they don’t.
Index funds take a different approach. They are called “passive management” funds. Their job is to buy the stocks in an index (whichever index they track). The only thing they have to do is buy and sell just enough to match the index. The idea with index funds is that they give you a diversified basket of stocks that are good enough to be in the index. Because they have a lot less work to do, their fees and expenses should be very low. They are guaranteed to give you the return that the index returns. They could be a loss, because index returns go both ways. But the history says that the stock market goes up eventually, if you are looking at results over many years, so they will probably do well over the long term. One famous person who recommends index funds for non-professional investors is Warren Buffet.
If you own an active management fund, you might or might not get SpaceX added to your holdings after its IPO. It will depend whether SpaceX fits into the fund’s investment thesis. If you own an index fund that tracks stocks like SpaceX, and SpaceX fits the criteria in the index, you will end up with SpaceX stock in your fund within a year or so of it’s IPO.
Does it make sense to invest your 401k in an index fund? In most 401ks the only alternative is an active management fund that might or might not do any better. There are a few 401ks that might let you invest in individual stocks, but those are more rare. Investing in individual stocks is much more difficult. It only makes sense for people who are willing and able to do a lot of research and stay on top of the market so they know when to buy and sell.
For most people whose career is anything other than studying financial markets, investing in an index fund in your 401k is the likely very smartest thing you could do. Even if SpaceX has an IPO.