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2 ETFs Riding Record Year For IPOs

Sumit Roy, ETF.com

The late 1990s were known for their excesses. Stock prices traded at frothy levels that didn’t reflect reality, as investors tossed billions of dollars at anything with “dot-com” in its name.

The threshold for initial public offerings (IPOs)—shares issued into the public market for the first time—was ridiculously low, and countless companies took advantage, raising huge sums of money for questionable business models. Remember Pets.com?

The high-water mark for IPOs was set in 2000, when companies raised $97 billion, according to Renaissance Capital. No year since has come even close to matching 2000 for IPOs (2014 was the closest, at $85 billion), until now.

Renaissance says the deluge of big-name IPOs in 2019 could lead to the best year ever for IPOs. The firm sees the potential for more than 220 IPOs that could raise more than $100 billion. UBS adds that the total market capitalization of these companies could exceed $600 billion.

The ride-hailing company Lyft IPO’d late last month at a $24 billion valuation, putting $2.2 billion in its coffers. Its main rival, Uber, is hoping to raise $10 billion at a $100 billion valuation when it IPO’s next month in what could be one of the 10 largest IPOs ever.

That could be just the start. Slack, Palantir, Airbnb and a host of other tech “unicorns”—private companies with valuations of more than $1 billion—could also start trading publicly this year.

First-Day Pop, Longer-Term Drop

For investors, getting allocated shares to a hot IPO could result in a windfall. It’s not unusual to see double-digit percentage gains from where an IPO prices to where it begins trading on the secondary market. Shares of PagerDuty surged more than 59% in their debut last week, and even Lyft, which stumbled in the days following its IPO, jumped 8.7% on its first trading day.

According to data from UBS and University of Florida professor Jay Ritter, since 1980, the average first-day gain for IPOs has been 18%. That’s nothing to sneeze at—most investors would take a one-day 18% gain without a second thought.

Unfortunately, most investors are unable to get allocated shares in an IPO before it hits the public markets. Those shares predominantly go to investment banks and their top institutional clients.

Instead, investors interested in an IPO will usually have to go to the secondary market to purchase shares of a new stock, after the first-day spike has already taken place.

Buying IPOs this way leads to much less impressive returns. According to the UBS/Jay Ritter data, five-year returns for IPOs purchased on the secondary market were negative in 60% of cases. Though on the positive side, a small handful of stocks had phenomenal returns of hundreds or even thousands of percent.

Those big winners are why the average five-year return for IPOs is 11%, though that is still 2% below the return of the benchmarks.

IPO ETFs Outpacing Market

The data seems to suggest that blindly buying all IPOs on their first day of trading isn’t a long-term winning strategy. Still, the chance to invest in the next big growth stock like Google or Apple is a seductive thing, so investors will almost certainly stay interested in IPOs.

The IPO strategy has even found itself a fan base among ETF investors. There’s a handful of ETFs out there that hold shares of newly minted IPOs, including the First Trust U.S. Equity Opportunities ETF (FPX), with $1.1 billion in assets under management (AUM), and the Renaissance IPO ETF (IPO), with $37 million in AUM.

The smaller IPO ETF has done well this year, gaining 30.5%, just short of double the S&P 500’s 16.4% gain in the same period. The competing FPX hasn’t done as well this year, but its 20.2% gain still outpaces the S&P 500.

YTD Returns For FPX, IPO, S&P 500

Note: Data measures total returns for the year-to-date period through April 17

Measuring Performance

To be sure, returns over a 3 1/2-month period don’t tell the whole story. It’s more informative to look at returns for these funds over longer time horizons.

For instance, since its inception in October 2013, IPO is up 57.7%, less than the S&P 500’s 89.9% gain, and less than rival FPX’s gain of 86.9% in the same period.

So, while IPO may be outperforming this year, FPX is leading the charge since Q4 2013, and both are underperforming the S&P 500 since then.

That said, it’s a completely different picture when you go back all the way to April 2006. That’s when FPX made its debut. Since then, it’s up a whopping 312.8%, easily trouncing the S&P 500’s 196.1% return in the same period.

It goes without saying, the time period you measure impacts the returns you will see. But it certainly seems FPX has a superior track record compared with that of IPO, one that handily outpaces even the broader market.

But as the old adage says, past performance is no guarantee of future results. This year’s outperformance in IPO speaks to that.

Focus On Largest IPOs

The wildly different portfolios of the two ETFs explain the differences in returns. FPX holds positions in the 100 largest recent IPOs, purchased after the close of the sixth trading day and held for approximately four years.

The ETF captures “around 85% of total market capitalization created through U.S. IPO activity during the past four years,” according to issuer First Trust.

The competing ETF, IPO, isn’t much different, in that it captures the top 80% of the market cap of new IPOs. It adds “sizable” IPOs on a fast track basis—Lyft was added to the fund a week after it came to market—while other IPOs are added during scheduled quarterly reviews.

Both ETFs’ focus on larger IPOs may be beneficial for their returns, as studies suggest companies with revenues exceeding $1 billion when they debut perform better over the long term.

Big Differences

Where IPO and FPX significantly diverge is their holding periods. FPX aims to own its stocks for around four years; IPO kicks them out after two years.

Another difference is that if a stock is acquired or merges with another, FPX will hold the stock of the acquirer or merged entity, something rival IPO won’t do. That’s resulted in some unusual names ending up in FPX’s portfolio, such as Verizon, Stryker, Dow, Tyson Foods, General Mills and Hershey, among others—stocks of mature companies that have been around for ages and could hardly be considered fresh IPOs.

Because of its more targeted exposure and shorter stock holding period, IPO gets the nod as the purer play on IPOs, even though its historical performance and liquidity pale in comparison with FPX.

Read the original article on ETF.com