What are IPO ETFs

An IPO ETF is an exchange-traded fund that tracks initial public stock offerings (IPOs) by a company. It attracted investors because it follows 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.

The Origins of IPO ETFs

The First Trust IPOX-100 (NYSE:FPX) was the first available IPO ETF, launching in early 2006. The IPOX-100 reflects the performance of the 100 largest IPOs, which gives investors the opportunity to benefit from those companies’ successes. 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.

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 which were thinly traded or overly volatile.

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 in which the IPOX-100 Index Fund does not allow for enormous first-day gains 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

IPO ETFs are especially vulnerable to economic declines, which is evident, as the credit crisis limiting the financing capabilities for new companies. 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.

The problems for IPO ETFs

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 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.

All in all, IPO ETFs are becoming more reliable and stable as the market becomes more comfortable with them. when evaluating IPO ETFs, we need to remember that they invest and divest on a quarterly basis and have a seven-day purchasing and 1,000 day selling rule.