FPX: A Diversified Approach To IPO Investing
‘FPX: A Diversified Approach To IPO Investing,’ in Seeking Alpha
FPX has benefited from strong momentum among high-growth IPO stocks in recent years.
While FPX has outperformed the broader market with an impressive 45% return in 2020, the fund has trailed the competitor ‘IPO ETF’ which is more concentrated on smaller companies.
We like the diversification of FPX which helps balance its risk and may ultimately prove to be the superior IPO investing strategy over the long-run.
FPX tracks the IPOX 100 U.S. Index which itself is a subset of the larger IPOX Global Composite Index. The index measures the performance of all recent IPOs and spin-offs/carve-outs globally during their first 1,000 trading days. From the group, the largest 100 U.S. based companies ranked by market cap are selected for the fund, subject to a 10% weighting cap. Other screening metrics include a minimum 15% float at the time of the IPO along with a minimum market cap of $50 million.
According to the index provider, the concept of IPOs is that the group represents a distinct equity market sector which data shows have skewed long-run return distributions. From the index philosophy statement:
“IPOX Schuster’s (“IPOX”) philosophy is to classify New Listings such as IPOs (Initial Public Offerings) and Spin-offs as a distinct equity sector for a substantial period of time in aftermarket trading because – as a consequence of the “going public” event – IPOs and Spin-offs possess unique return dynamics. Some of these empirical features may concern short-run over-performance, a highly skewed long-run return distribution with relatively few companies driving positive performance and significant return differences when measuring IPO and Spin-off returns of sub-groups of companies.”
The holdings are reconstituted and rebalanced quarterly to ensure that each company remains among the top 100. For context, 1,000 trading days is approximately four calendar years, but there is some flexibility to extend these holding periods. Notably, to manage turnover and market impact, securities may have their index weighting gradually reduced so that it is included in the fund beyond 1,000 days. The result here is that the FPX is tilted towards mid- and large-cap stocks that remain among the largest IPOs over a four-year period.
It’s important to understand how the fund is constructed because taking a look at the current holdings, there is a combination of recent IPOs like Palantir Technologies Inc (PLTR), which currently has a 1.3% weighting, along with some other stocks like Tesla Inc. (TSLA) with a 3.4% weighting that has been publicly traded for over a decade. With Tesla, the stock’s weighting at 3.4% is lower than what its market cap would imply, suggesting its composition in the index has been reduced gradually at the discretion of the index sponsor.
The fund’s top holding is currently Snap Inc. (SNAP) with an 8.8% weighting that launched its IPO back in 2017. SNAP has been a big winner this year with shares up by more than 210%, adding to its importance in the fund. Other notable recent IPOs include Zoom Video Communications Inc. (ZM), The Trade Desk Inc (TTD), and DraftKings Inc. (DKNG). Airbnb (ABNB) is one of the newest holdings in the fund and currently has a 0.4% weighting.
There are also stocks like Thermo Fischer Scientific Inc. (TMO) representing 4.7% of the fund, Eli Lilly and Company (LLY) with a 3.3% weighting, and Dow Inc. (DOW) with a 2.5% position which are included in the FPX fund based on their involvements with recent spin-offs and corporate actions. While these companies may in fact be relevant to themes in IPOs from recent years, they don’t necessarily come to mind when thinking of the hottest IPO stocks. As we discuss below, the value is that these companies add to the diversification and help balance the risk.
As mentioned, it’s been a strong year for IPOs and the broader stock market. Despite the pandemic, an all-in approach to stimulus measures from the Fed and on the fiscal side has supported financial conditions, allowing investors to look ahead towards the recovery. Technology companies, in particular, have been relatively resilient to the economic disruptions and in some cases even benefiting with a boost of demand based on changing consumer and business spending dynamics from trends like work from home.
FPX’s 45% year-to-date return has been driven by massive gains from key holdings, including a 664% rally in shares of Tesla, 482% return for Zoom Video Communications, and 372% return for DraftKings Inc. among top 20 positions.
While FPX shareholders should be feeling pretty good about the performance, we highlight an alternative ETF that is also focused on IPOs with an even more impressive gain this year. The Renaissance IPO ETF (IPO) has returned 110% in 2020, more than doubling the return from FPX, and the Invesco QQQ ETF (QQQ) up 44% year to date.
The IPO ETF takes a different approach to capture exposure to this market segment by focusing only on companies that began trading within the last 2 years. The fund with only 48 current holdings is more concentrated in these newer IPO stocks along with more exposure to smaller companies which has been a winning strategy this year.
While the performance this year speaks for itself, our view is that the stronger gain from the IPO ETF doesn’t necessarily make it a better or superior fund compared to FPX over the long-run. In many ways, FPX benefits from its broader approach to IPO investing which adds diversification across 100 stocks and can help lower the risk in a down market.
By holding IPO stocks for four years or longer, compared to the stricter 2-year max holding period from the IPO ETF, FPX can capture the upside from companies that gain momentum following a possible slow start as a public company. That’s the case with Snap Inc. which has had a breakout year in 2020 following years of underperformance since its 2017 IPO and is an one example of a stock in the FPX fund that is not included in the IPO ETF.
In hindsight, IPO would have clearly been the optimal investment this year, but the point of diversification is to be prepared for that uncertainty. A case can be made that 2 years is too short a holding period for IPO stocks and the fund can suffer from the inherent high turnover which effectively sells the winners.
With comparable historical data going back to the IPO ETF inception date in 2013, the chart below highlights that FPX had a positive return spread for the majority of the period. The cumulative spread of an approximate 35% advantage for IPO over the period is entirely based on just this year. It’s possible the FPX ETF may outperform the IPO ETF going forward to the upside or downside over any particular time frame based on broader equity market conditions.
Analysis and Forward-Looking Commentary
Overall, we like FPX and think its strategy may still prove to be superior compared to the alternative IPO ETF over the long-run. The attraction of the fund is that it offers investors exposure to a variety of companies that are not yet included in broad market equity indexes which adds to the potential of the fund as a portfolio diversifier. The high-growth and momentum profile of the underlying holdings also represents high-quality companies that have a positive long-term outlook as they build and consolidate their market shares.
The current development in the market is strong enthusiasm for the economic outlook with the rollout of the COVID-19 vaccine set to effectively end the pandemic by next year. The consensus is that the global growth environment will pick up the pace benefiting from tailwinds of ongoing fiscal and monetary stimulus measures. Pent-up demand for various consumer spending categories like travel, hospitality, and entertainment can be a strong catalyst for a strong recovery.
On the other hand, the concern here is that stock prices may have already more than priced-in the rosy outlook for 2021, adding to risks of valuation. In this regard, IPO stocks within the FPX ETF face the risk that growth at the macro level underperforms, pressuring sentiment in high beta names. A weaker-than-expected recovery pressured by lingering structural challenges like high unemployment could be a bearish theme adding to downside risks.
We balance our favorable view of the fund with near-term equity valuation concerns and rate shares of FPX as a hold. We think patient investors can find a more attractive entry point down the line following the next correction. Tactically, we would be buyers of shares under $90 which for context is a level the fund last traded at in September, so well within the trading range for the year ahead. Investors should monitor portfolio changes to keep track of the largest positions that are driving the fund’s return.