Investing In IPO ETFs

An IPO ETF is an exchange-traded fund (ETF) that tracks initial public stock offerings (IPOs) of various companies. Many investors are attracted to IPO ETFs because they follow a large pool of initial public offerings, rather than exposing the investor to one or a few selected companies. This process serves two main purposes:

1. To create greater ease and familiarity with IPO investing.

2. To allow for a greater degree of diversification against the traditionally volatile and unpredictable IPO market.

TUTORIAL: Exchange-Traded Fund Investing

The Origins of IPO ETFs
The First Trust IPOX-100 (NYSE:FPX) was the first available IPO ETF, launching in early 2006. IPOX-100 follows the U.S. market for IPOs based on the IPOX-100 U.S. Index - like the soaring stock prices following Google's (Nasdaq:GOOG) initial public offering in 2004. (To learn more about IPOs, read our IPO Basics Tutorial.)

The creation of IPO ETFs is a direct result of the many successful IPOs that were offered between 2004 and 2005. The attraction to investing in a company at its IPO is that the investor can get in on the ground floor of a newer company with high-growth potential. In the past, investors have reaped large gains from successful IPOs, like the 2006 public offering of Chipotle Mexican Grill (NYSE:CMG), in which the stock price doubled on its first day as a public company. This vehicle came together at a time when the popularity of ETFs was soaring, and many investors distinctly remembered the investment losses realized by those who took the risk of investing in one-off IPO securities in the late 1990s. (For more, read The Murky Waters Of The IPO Market.)

IPOX: Not All-Inclusive
However, the IPOX Index has specific stipulations that would prohibit it from including IPOs like that of Chipotle. The IPOX Composite does not include companies with a more-than-50% gain on the first day of trading; this was put in place to avoid those securities that were thinly traded or overly volatile. Many IPOs are known for being bid up within the first weeks or months, only to drop back down to the original prices (or below) by the end of their first year on the market.

The index also excludes issuing companies for a variety of other reasons. Only United States corporations are accepted, and a number of investment vehicles are excluded, such as real estate investment trusts, close-ended funds, American depositary receipts from non-U.S. companies and American depositary receipts from foreign companies, as well as unit investment trusts and limited partners.

Companies that meet the requirements for the IPOX Composite also need to have a market capitalization of $50 million or more. Additionally, the initial public offering must provide at least 15% of total outstanding shares. Another way that the IPOX-100 Index Fund does not allow for enormous first-day gains (like that of Chipotle) to be included within the portfolio is through only investing in securities after they have already been on the market for a period of seven days. In addition to having to be publicly traded for this period, securities are removed from the fund on their 1,000th day of trading, which means that the index could suffer when a major performer is removed.

Rules of the Fund
Google is a good example of how this 1,000-day limit can hurt the index. Google was the top performing company in the IPOX-100 index when the IPOX-100 ETF was launched, but exceeded the 1,000-day limit in 2009. The 2008 decline in the performance of the IPO index suggests that IPO ETFs are especially vulnerable to economic declines. The IPO index that the IPOX-100 ETF follows struggles to perform during difficult economic periods. Also, the vulnerability to a single major company in the index illustrates the inherent danger in IPO ETFs.

Another timing-based rule the fund has in place is that companies are added or removed from the index on a quarterly basis, which could potentially limit the IPOX-100 ETF's returns. For example, if a company peaks during the quarter before the fund adds it, an ideal investing opportunity may be lost.

IPO ETFs Under Fire
Some critics charge that investing in an IPO ETF is risky. The risk of investing in companies that are going public is often associated with the "dotcom bubble" of start-up companies. In the late 1990s, many companies were valued unusually high, which created a public buzz around initial public offerings. However, many of these companies collapsed shortly after the IPO, and investors lost considerable amounts of money. In recent years, underwriters seem to have adjusted to more accurate pricing for IPOs, and thus the IPO index has been more stable and predictable. Another potential problem for IPO ETFs is that the IPO companies, usually relatively small corporations, will be more prone to failing in a down market than well-established companies will. (For more, see Market Crashes: The Dotcom Crash.)

The Bottom Line
It is yet to be seen whether this unique way of gaining exposure to IPOs will grow, but it is certainly unique. While there are some rules that make IPO ETFs risky and limited in returns(i.e. they invest and divest on a quarterly basis; they have a seven-day purchasing rule, and 1,000-day selling rule), the funds are becoming more reliable and stable as the market becomes more comfortable with them. (To learn more about ETFs, see Introduction To Exchange-Traded Funds and Exchange Traded Funds Special Feature.)