Index Funds Will Pay Dearly for Newest Member of S&P 500

About 100 index funds will be trying to buy America Online, even as it is trading around all-time highs.
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Here's a chance for active mutual fund managers to gain some ground on the indexers.

Tuesday's announcement by

Standard & Poor's

that it would add

America Online

(AOL)

to its

S&P 500

index will surely cause a rash of trading in that stock Dec. 31. At the close that day, AOL will officially become listed. Index fund managers, who try to match the returns of the index as closely as possible, will want to get in as of that moment.

With AOL trading at an all-time high at one point today of $141, those managers will have to pay dearly to get it.

"Looks like they'll be buying it at the top," says David O'Leary, of

Alpha Equity Research

in Portsmouth, N.H.

Consider the mammoth, $70 billion

(VFINX) - Get Report

Vanguard Index 500 fund. With AOL set to comprise about 0.6% of the S&P 500's total $9.7 trillion market cap, the fund will need to match that weight in its portfolio. That works out to about $420 million worth of AOL stock that Gus Sauter, the

Vanguard Group's

human being behind the huge indexing machine, will need to buy.

Sauter says in order to match the returns of the index closely, he won't start buying AOL until about 1 p.m. on Dec. 31. At 138 1 /2, AOL's closing price today, that would translate into about 3 million shares of the stock for his portfolio.

With more than 25 million shares of AOL exchanged today (average daily volume is 14.7 million shares), he probably won't have a problem getting those shares, but he will have competition for them. After all, there will be about 100 other S&P 500 index funds trying to get those shares at the same time, so chances are Sauter will be paying a premium. But in many aspects, that is simply the nature of the indexing game.

As AOL's stock has risen 512% this year, many active fund managers have ridden the stock to keep pace with -- or even beat -- the S&P 500. Selling it now will give those active managers an opportunity to take profits, while indexers will be forced to buy high.

"The timing is bad for anybody indexing, but the timing is good for anybody actively managing the portfolio" with AOL, O'Leary says, "because

AOL has helped them beat the index on the way up, and now they have an opportunity to sell it at $138 per share."

Sauter says there's another factor about AOL that will affect index funds. America Online has a market cap of $63.4 billion, an unusually large market cap for an "add" to the S&P. The companies Sauter usually buys on an add to the index are around $15 billion in market cap, he says.

"Most indexers are going to have to sell off some stocks to raise cash to buy AOL," Sauter says. "We're certainly going to have to divert a lot to AOL. It's a big position. It's a large company."

And Sauter also knows that those indexers probably will see short-term declines in the stock after its initial boost from being added to the index wears off.

"We do see over the following month that the price does tend to go back down," he says about stocks added to the index

But over time, the S&P 500 Index has tended to go up, which is what indexers are betting on. And with their kind outperforming almost nine out of every 10 active fund managers this year, don't look for indexers to have egg on their faces anytime soon.