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ETFs with the Potential for Capturing the “New Listing” Premium

Ryan O. Issakainen | First Trust Advisors L.P.

Summary of Q2 2019 ETF Flows and Trends

• Total US-listed ETF assets reached$3.99 trillion at the end of Q2 2019, a 12.8% year-over-year increase. Estimated net asset flows in Q2 2019 totaled $80 billion, slightly above the prior four quarter average of $74 billion.
• Taxable Bond ETFs received the strongest estimated net inflows in Q2 2019, totaling$39 billion, the strongest quarterly estimated net inflows for the category on record. Municipal Bond ETFs received$2.3 billion in estimated net inflows in Q2 2019, increasing year-over-year assets by 27%.
• US Equity ETFs received the second highest estimated net inflows with $37 billion, bringing the category’s year-over-year increase in total assets to 16%. The narrower Sector Equity ETFs category saw estimated net inflows of $510 million, reversing the estimated net outflows of the two previous quarters.
• International Equity ETFs received $1.6 billion in estimated net inflows, increasing year-over-year assets by 5%.
• Alternative and Allocation ETFs had estimated net outflows of $0.5 billion and $0.2 billion, respectively, in Q2 2019.

Initial public offerings, or IPOs, often generate significant media attention, largely due to the outsized returns that may occur on a stock’s first trading day. New listings tend to favor innovative and potentially disruptive stocks that intrigue investors. But beyond the initial excitement of new listings is another investment story that has received much less attention. During the first three or four years of after market trading, IPOs and spin-offs have often exhibited distinct return characteristics that may provide opportunities for investors seeking to outperform the broader equity market.
Below, we take a closer look at three First Trust ETFs which seek to exploit the unusual pattern of returns for new listings, examining some of the distinct performance drivers for these stocks, and how investment advisors may consider utilizing these funds.

Skewed Aftermarket Performance

Simply put, apart from the first trading day, most new IPOs and spin-offs have tended to perform rather poorly during their first few years; however, average returns for the group have been quite strong. This divergence is explained by the strong performance of leading stocks, which has more than compensated for the poor performance of laggards. Thus, a diversified approach that captures the“average”—a“new listing”premium—may be desirable,even while the likelihood of choosing individual winners is relatively low.

IPOX Schuster studied the aftermarket performance of over 5,000 IPOs and spin-offs that began trading in the US from 1985 to 2018 (See Table2 and Chart 1).They found that after 12, 24, 36, and 48 months (excluding the first trading day), over half the stocks in the universe had generated negative returns. At the end of 48 months, the median cumulative return was -19.8%. However, over each of these time periods, average returns were significantly better, with cumulative gains reaching +42.5% after 48 months. According to IPOX Schuster, a similar pattern can be observed outside the US as well.

One challenge for investors seeking to pick only the best recent IPOs and spin-offs is the relative lack of information known about newly listed stocks compared to those that have been publicly traded for a longer period. As the number of research analysts covering new listings grows, and as management teams attempt to perform in the public eye, this information gap narrows, and the return dispersion between these stocks grows.
Hence, we believe investors are better off owning a diversified portfolio of recent IPOs and spin-offs—seeking to achieve“average”returns—rather
than attempting to hand pick a small number of these stocks.

Three Strategies for Investing in IPOs & Spin-offs

Investors seeking diversified exposure to a portfolio of recent IPOs and spin-offs have three options among the First Trust line up of ETFs. The most seasoned of these is the First Trust US Equity Opportunities ETF (FPX), which tracks the IPOX®-100 U.S. Index. This index is comprised of 100 of the largest recent IPOs and spin-offs domiciled in the US that have begun trading over the prior 1,000 trading days (approximately four years). For those seeking exposure outside the US, the First Trust International Equity Opportunities ETF (FPXI) invests in 50 of the largest new listings internationally, and the First Trust IPOX® Europe Equity Opportunities ETF (FPXE) invests in 100 of the largest new listings in Europe.

Fertile Ground for M&A Activity

Mergers & acquisitions (M&A) have been a distinct driver of returns for recent IPOs and spin-offs in recent years, according to IPOX Schuster. Over the past 10 years, nearly 18% of the US IPOs tracked by IPOX Schuster were acquired within the first four years of trading, many at significant premiums to the stock’s pre-announcement market price.

One recent example was the acquisition of electronic payment provider First Data—a stock that had its IPO in October 2015—by Fiserv, in an all stock deal consummated in July 2019 at an 81% premium to First Data’s closing price prior to the deal’s January 2019 announcement. Another example was the acquisition of US biotechnology company AveXis—a stock which had its IPO in February 2016—by Swiss pharmaceutical Novartis. This deal was consummated in May 2018 at an 88% premium to AveXis’s pre-announcement closing price. Because recent IPOs and spinoffs are often at the forefront of growth and innovation in their respective industries, we expect them to remain attractive targets for M&A activity.

Beyond Broad Benchmarks

Many broad benchmark indices require new listings to trade for a period of time before becoming index eligible. This provides another distinct source of potential performance for investment strategies—such as the aforementioned three ETFs—that can invest in stocks before they are added to broad benchmark indices. One prominent example for FPX was its addition of Facebook in September 2012, well before it was added to the S&P 500 Index in December 2013. During this period, Facebook gained roughly 150%, providing a significant source of outperformance for the ETF.
More recently, FPX captured strong returns from cybersecurity provider Zscaler, which went public in March 2018. The stock had a total return of 95% through the first six months of 2019, yet remains excluded from the S&P 500 Index despite having a larger market cap than 94 of the current index constituents.

Where Do These Strategies Fit?

Over the years, investment professionals have utilized FPX, FPXI, and (more-recently) FPXE in a variety of ways. One popular strategy has been to pair these ETFs with complementary funds that are positioned to perform well in different market environments. For example, FPX has often been combined with the more defensively postured First Trust Value Line® Dividend Index Fund (FVD). Others have utilized these ETFs to expand the breadth of their underlying portfolio holdings beyond those of broad benchmarks. Still others have used these ETFs as substitutes for traditional large-cap growth funds, or even as a more liquid, low-cost alternative to private equity deals, as many large IPOs are private equity-backed.

Performance

The track record of the highlighted three ETFs has been relatively strong, providing significant outperformance versus broad benchmark indices. The US-focused FPX has outperformed the S&P 500 Index by over 3% per year on an annualized basis, since the fund’s inception (4/12/2006). The international-focused FPXI has outperformed the MSCI World Ex-USA Index by over 1.5% per year on an annualized basis, since the fund’s inception (11/4/2014). And the European-focused FPXE has outperformed the MSCI Europe Index by 1.9% since its inception (10/4/2018). Year-to-date, as of 6/28/19, FPX, FPXI, and FPXE have outperformed their benchmarks by 7.3%, 4.6%, and 6.8%, respectively.
For many, IPOs are regarded as tools for short-term speculation. Successor failure is judged by how well a stock performs on its initial trading day. But this perspective obscures some of the unique and potentially beneficial characteristics of recent listings, in our view. For investors seeking to gain exposure to the longer-term benefits of these stocks, and the new listing premium, we believe these three ETFs provide an unemotional, rigorous, and disciplined approach.

Performance Summary(%)

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