Investing in an IPO ETF

Briton Ryle

Updated October 18, 2013

Investing in IPOs has always been a shot in the dark. Even if a new issuance’s prospectus paints an attractive picture of the company’s future prospects, no one really knows how the market will respond during the first few months of trading.

You can luck out and get in on something like Noodles (NASDAQ: NDLS), which started trading at $32, shot up to the low $50s within two days, and currently trades at $46 for a 43% gain in just four months. Or you can get hammered by something like Groupon (NASDAQ: GRPN) which first opened at $28 and fell to $16 within a month, on its way to $2.60 right on its one year anniversary.

stock exchangePerhaps the best way to trade IPOs is to invest in an assortment, thereby spreading out the risk. That’s the intent of a new ETF dedicated to IPOs, which debuted this Wednesday under the ticker symbol – you guessed it – IPO.

The Renaissance IPO ETF (NYSE: IPO), managed by Renaissance Capital LLC, a global IPO investment advisory firm, “is designed to provide investors with efficient exposure to a portfolio of newly public companies prior to their inclusion in core U.S. equity portfolios,” the company describes at its website.

Now you can let the experts figure out which IPOs stand the better chance of generating positive returns. Yet there are some cautionary characteristics of IPO funds that investors ought to be aware of before determining whether to include them in their portfolios. We’ll get to those after the fund’s profile.

The Fund’s Basics

The objective of the Renaissance IPO ETF is to provide investors with exposure to public companies that have not yet been added to the major indexes and ETFs, thereby filling a void.

“A portfolio of unseasoned publicly traded equities provides investors with more comprehensive exposure to the full set of U.S. public equities,” Renaissance Capital Chairman Kathleen Smith informed the NASDAQ exchange. When included next to the major indices, the IPO ETF can round out your exposure to the overall U.S. market.

“The Renaissance IPO ETF includes the most economically significant newly public companies by tracking the rules-based Renaissance IPO Index, designed by Renaissance Capital research to hold the largest, most liquid newly-listed U.S. IPOs,” the company elaborates. “New companies are included in the index 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.”

Opening its first trading day at $20, the stock held to a half-dollar gain by day two, with some 251,000 shares trading of a total 1.5 million shares outstanding, for a total fund value of nearly $30.66 million. The prospects look promising if the ETF manages to track the benchmark it is based on – the Renaissance Global IPO Plus Aftermarket Fund (IPOSX), which is up 47% over the past 12 months.

Cautionary Characteristics of the IPO Market

Perhaps the most impacting characteristic of the IPO market is its amplification of the overall market sentiment. All stocks reflect the general sentiment of the marketplace pretty well, as they perform well during market booms and sour when the market busts. But IPO activity tends to exaggerate that.

When the market is hot, IPOs come out in droves to take advantage of heated buying interest that often pays a premium for new offerings. But when markets are cold and even long established companies trade at a discount, new public offerings are almost nowhere to be found.

As a result, IPO indices and funds can be highly volatile. The Renaissance Global IPO index on which the new Renaissance IPO ETF is based skyrocketed from $10 to $46 at the pinnacle of the dot-com IPO craze from 1998 to 2000 – only to crash to $8 a year later. It then rode the housing bubble when REIT IPOs were all the rage, rising from $6 to $16 by 2008 – only to crash back down to $8.50 in a year and a half.

The flurry of IPOs recently has again lifted the index from $10 to $16 in the past 12 months. But many have already begun speculating that the increased IPO activity may be a sign that the markets are about to correct, with companies hurrying to go public while the buying is still robust.

“That’s because the IPO market is a reliable barometer of how overheated the investment arena has become,” explains Mark Hulbert to MarketWatch. “When companies are rushing to sell their shares, it often means that the overall stock market has become not just fairly valued, but actually overvalued.”

Since most spurts of IPOs usually happen at the later stages of a sector’s cycle when it is cresting, IPO funds can give you those spikes and plunges like those seismic scribbles on a seismograph.

Another caution with IPO funds is their lack of sector diversification, as public offerings tend to launch in clusters in the sectors that are hottest. Since new companies are added to the fund five days after their public debut and kept for a maximum of two years, the fund’s portfolio will often be highly weighted toward the latest sector to be brimming with IPOs. This tends to narrow an IPO fund’s spotlight to a fine beam, with concentrated rather than broader market coverage.

And of course, there is the unproven public record of new issuances. Even if the company has a proven history of generating profit as a private enterprise, going public can disrupt that performance. Though it does vary from company to company, transitioning from private to public can be pretty turbulent and may involve adopting a whole new management style.

But if you do not mind a fund that rides market sentiment with gusto, that regularly shifts from sector to sector as the IPO herd migrates from one area of the economy to another, and that contains companies that often operate more on optimism than on proven track records, then an IPO fund could well fit into a portfolio for those periods of hot IPO activity, such as we are in now.

Joseph Cafariello

 

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