September 21, 2014

Investing in IPOs with an ETF

The Renaissance IPO ETF is a pretty cool concept:
Here's how it works: New companies are added to the Renaissance IPO ETF on a fast entry basis on the fifth day of trading, or upon quarterly review, and are removed after two years when the IPOs become seasoned stocks.
Then there's the much bigger, and much older, First Trust US IPO Index Fund (FPX), that tracks the IPOX 100 US index. Rather than removing constituents after two years like the Renaissance fund, FPX tracks the 100 largest, most liquid IPOs and holds them for 1,000 trading days. The index is reconstituted quarterly. It also caps the largest constituents at 10% of holdings.

Both follow a passive indexing approach to IPOs. Just like I have no faith in my ability to pick stocks, I have no faith in my ability to figure out which IPOs are going to be hot and which ones are going to flop. For over a year after its IPO, it looked like Facebook was going to fall into the latter category. Investors who were lucky enough to get in near FB's low would have seen their money more than quadruple, or those who got in last summer would have seen it triple. Even buyers who got in right after the IPO would have doubled their investment. Then we've got cases like King Digital (KING) or Zynga (ZNGA). Both currently trade at significantly lower valuation than when they went public.

The Renaissance IPO ETF lets investors get exposure to stocks that have just gone public
IPOs tend to be volatile and cherry-picking the best is not for the faint-of-heart. That's where the idea of buying a broad basket of newly-public stocks is an intriguing idea. You can potentially smooth out your returns by offsetting the big losers with an occasional 300-400% gain (no guarantees, of course). The Renaissance ETF works by tracking the rules-based Renaissance IPO Index. According to Renaissance, the index:
...was designed to track the activity and performance of IPOs from developed and emerging markets. The Index Series is composed of a rolling two year population of IPOs and employs a float-adjusted market capitalization weighting scheme to account for only those shares that are publicly available for trading.
The ETF's fact sheet lists the top 10 holdings, which combine for a bit over 45% of its total assets. Currently, Twitter (TWTR) is the largest holding at 10.1% and Zoetis (ZTS) accounts for 9.8%. Nearly 20% tied up in just two stocks is pretty concentrated, but the rest of the top 10 holdings individually account for anywhere from 5.3% down to 2.3%. Renaissance Capital also offers an actively managed mutual fund (the Global IPO Fund - IPOSX) with 32 holdings. It's a different beast from the more passive approach of the ETF. It shows in the top 10 holdings, where Facebook, Envision Healthcare, and EQT Midstream are the largest at 7.9%, 5.3%, and 5.3% respectively.

IPO hasn't yet been trading for a full year, so time will tell how well this strategy works. It will be fascinating to see how it look 5-10 years out. With an expense ratio of 0.6%, it's significantly higher than a passive index fund, but somewhat reasonable considering there's not much else like it on the market. An individual investor attempting to replicate this strategy with individual stocks would quickly rack up some hefty commissions, so expenses seem fair. Currently, its average trading volume is just shy of 26,000 shares daily, and total net assets are a bit over $34 million, so it's still relatively small. We'll see if it can pick up some momentum over the next few years. In the limited history we do have, it's just about matched the performance of the S&P 500, albeit with more volatility. How about the more established FPX?

First Trust US IPO Index Fund (FPX) compared to SPY, IJH, and IWM
FPX gives us much more historical data to work with. In fact, more than 8 years worth, going back to April of 2006. This performance is quite interesting. Through 2006 and 2007 FPX pulled ahead of the three market cap indexes. In early 2009 at the market bottom, FPX was down 31%, identical to the S&P 500 during the same stretch (and better than small and mid cap stocks). Once the recovery began, FPX took off and never looked back. In fact, over this stretch of 8+ years, the First Trust US IPO Index Fund is up a massive 175%! Of the three broad market cap segment indexes, mid caps did the best during that time. The return for the S&P 400 was a fantastic 102% but was completely and utterly outclassed by FPX. This fund's holdings look quite a bit different than the Renaissance ETF. The top couple of holdings are similarly highly-concentrated: Facebook and AbbVie are about 10% and 9% of FPX respectively. You'll also see names like General Motors, Phillips 66, Kraft, and Hilton, among others. The longer holding period may account for a large part of the differences in holdings. FPX also skews toward larger companies, with a $21 billion average market cap compared to about $8 billion for IPO. The expense ratio here is similar to IPO as well, at 0.66%, but FPX has a solid $526 million in net assets, trading over 70,000 shares/day.

IPO filings can vary widely from year-to-year. We're nearing 300 for 2014, but hardly broke 100 back in 2008. I'm not sure what kind of impact this will have on these exchange-traded funds. If we encounter another dry spell, it's tough to say if some of the holdings could become even more concentrated if we have just a handful of highly-liquid IPOs in a given year. In any case, IPO historical yearly performance is pretty strong. From what I can tell, these numbers assume investors are able to purchase at the IPO price. If you look at the first day pop chart to the right of IPO returns, it looks as if that pop accounts for a large portion of the overall returns. Given that the Renaissance fund adds holding on the fifth day of trading, the returns from the initial pop may not be captured. Conversely, buying in on the fifth day could be advantageous for some equities.

Nevertheless, even if you wanted to get in at the IPO price for some of the hottest new issues, it can be challenging to do so. You have to be approved by your broker, and there are no guaranteed any particular broker has enough shares to be demand at the IPO price. I recently came across a company called LOYAL3 that offers fee-free investing in a limited set of big brands. They claim to offer the opportunity for individual investors to get into IPOs for as low as $100, but I'm not sure if the success rate would be any better than with any other broker.

Given the performance of the First Trust fund, consistently outperforming over a relatively long stretch of time, it's hard to argue for going after individual issues when the fund has done so well. And regardless of any concerns about capturing IPO first-day pops, FPX looks to have overcome this issue over the years. Most impressively, many ETFs that drastically outperform indexes over time seem to be subject to much greater volatility, often dropping below broad market index returns. That doesn't seem to be the case here. Much of the outperformance seems to have to do with the high concentration of its top holdings. Over the past couple of years, for example, Tesla is up over 750%, a few other components are up over 150%, and Facebook has doubled in price. Considering the top 10 holdings make up nearly 50% of the ETF, 3 or 4 of these doing well (or poorly!) can have a dramatic impact on the overall price. It definitely merits a closer look, regardless.

As usual, it's my goal to help people find new investing ideas for further research. However, please don' take my word for it. Trade only after consulting numerous well-regarded sources of information and after speaking with a financial professional.

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