Beyond Meat Inc., Pinterest Inc. and Zoom Video Communications Inc. saw their stocks soar during their market debuts recently, and they are still flying above their initial public offering (IPO) prices.
Lyft Inc.’s shares surged on their first day, too, but have since tumbled below their listing price. And Uber Technologies Inc.'s stock has yet to trade above its IPO offering.
Welcome to the world of hot IPOs, in which new public shares can result in eye-popping gains for some investors or frustration when the stocks lose their sizzle. Picking individual winners can be a crapshoot, but exchange-traded funds (ETFs) offer a potentially less risky way to play the IPO boom.
Although Apple Inc. and Facebook Inc. were profitable before listing, more high-profile IPO unicorns – startups valued at US$1-billion or more – are money-losers coming out of the gate. And some are staying private longer thanks to mega-rounds (at least US$100-million raised) of venture-capital funding.
“One of the concerns for some of these companies is when are they going to reach profitability,” says Jay Ritter, a finance professor at the University of Florida, who has long studied the IPO market. “And are the valuations so high that the upside potential has been taken away?”
Zoom Video Communications, which provides remote conferencing using cloud computing, is “growing fast and is profitable, but it’s trading at a price/sales ratio of [more than] 60,” Mr. Ritter says. “The company has to grow its sales and profits by a huge amount in order to keep the stock price from falling.”
Heavy IPO activity tends to occur when markets hit all-time highs, but it’s difficult to say whether that is the right time to invest in new listings, he says. Former U.S. Federal Reserve Board chairman Alan Greenspan described stock gains in 1996 as “irrational exuberance,” but the market continued to climb for the next three and a half years, he recalls.
Investors should not consider all IPOs in the same way, Mr. Ritter says. Smaller-company IPOs tend to underperform the broad market in the three ensuing years, he notes. And tech-stock IPOs have done better than non-tech startups, whether measured from 1980, 1990 or 2001, he adds. “The 1999-2000 crop crashed and burned, but a number of those companies went on to later success.”
As IPO stocks can be risky, investors may want to consider IPO-focused ETFs because at least they are going to have diversification, Mr. Ritter suggests. “Even if there is industry concentration, it is not going to be just one company.”
Daniel Straus, head of ETF research and strategy at National Bank Financial Inc., agrees that IPO stocks inherently carry more risk. Retail investors may be seduced by the idea of owning a hot IPO, but investment banks usually restrict the supply of these pre-public offerings to favoured institutional clients.
Most of the retail crowd will have to buy the stock on the listing day or shortly afterward, likely from an institutional investor who was given an allocation, and “your trade will be lining their pockets,” says Mr. Straus.
Some retail investors may unknowingly participate in an IPO debut if they own a mutual fund that acquired those shares before the company went public. For example, Fidelity Investments Canada ULC’s Fidelity Founders Fund owns shares of Lyft while Fidelity Insights Fund holds Lyft and Pinterest stocks.
For retail investors who want exposure to potentially high-growth companies, ETFs that invest in IPOs can make sense because it can take some time before startups enter major indices, such as the S&P 500 Index or the Russell 1000 Index, says Mr. Straus. “But the first-day pop is not something any IPO ETF will be able to give.”
Among U.S.-listed IPO ETFs are two that target U.S. equities and three that focus on non-North American securities. But their strategies, including when they buy the IPO names, and returns also differ.
Among the U.S.-company IPO funds, First Trust U.S. Equity Opportunities ETF (FPX-NYSE) holds 100 stocks that include IPOs and firms spun off from larger companies. The ETF hangs onto the stocks for four years. Should any of the IPO stocks become the subject of a takeover, the ETF will keep the acquiring companies; that’s why its holdings include names such as Verizon Communications Inc., General Mills Inc. and Eli Lily and Co.
This ETF, which launched in 2006, recently acquired shares of Lyft and spinoffs such as Dow Inc. and Alcon Inc. It posted a 24.06-per-cent gain year-to-date until April 30, compared with 18.25 per cent for the S&P P 500 Index, including dividends. The annualized returns of this ETF have matched or outpaced the index over one, three, five and 10 years.
On the other hand, Renaissance IPO ETF (IPO-NYSE), which was launched in 2013, holds about 70 U.S. stocks for a two-year period. Its portfolio now includes Lyft, Pinterest and Zoom Video Communications, while Uber will be added on Fri. May 17. This ETF beat the S&P 500 Index with a 35.45-per-cent return for the first four months of this year, while its annualized return has outpaced the index over three years.
Although these IPO ETFs offer diversification and can outperform the broad market, there are times when they have steep pullbacks, too, says Mr. Straus. And past returns are not necessarily repeatable because these ETFs are constantly rebalancing and bringing in new stocks, he adds.
The Renaissance ETF is more of a pure play on new companies, but the First Trust ETF“is probably a safer bet,” he says. “Generally, we prefer low-cost index exposure, and would only consider either of these to be a small complementary position alongside a mainstream benchmark ETF.”
Todd Rosenbluth, director of ETF and mutual fund research at New York-based independent investment research firm Center for Financial Research & Analysis LLC, prefers the Renaissance ETF for investors who want exposure to new public companies.
That’s because “we like more of the stocks themselves that are currently in that IPO ETF,” says Mr. Rosenbluth. “Our research on ETFs is more forward looking. … The historical track record of an index ETF is less meaningful than the securities that end up in the portfolio.”
Still, he’s not pounding the table for any IPO-focused ETF. These funds are still expensive with fees of about 0.60 per cent compared with plain vanilla index ETFs, and they can be relatively volatile, he adds.
The Renaissance IPO ETF could complement a broadly diversified portfolio as part of a narrow slice devoted to riskier investments, he says. “These [IPOs] are still unproven companies that collectively will do well in a risk-on environment. But they are more likely to get punished when the stock market is not doing well.”