How To Invest In The IPO Wave

by: William Sabin

Everyone wants to get in on the IPO (initial public offering) market, but how do you diversify risk?

Is it possible to pick and choose which IPOs to invest in? The sales hype makes them all sound like they have huge potential.

Are we facing a year 1999-2000 spike in IPO related stock prices?

The "why" behind the articles I write about trading is to help others see through the array of articles and opinions of what someone should be invested in. If I meet my objectives, what I have to say will be done with clarify and simple language.


Using an Exchanged Traded Fund to diversify risk

As I have written about the marijuana industry on Seeking Alpha here on Kush (OTCQB:KSHB) and several times on Alternative Harvest ETF (MJ) here and here. One key element in a emerging industry are that there are so many players and not all will make it. The obvious objective is to pick the winners and avoid the losers. Of course, that is fairly hard to do. So, in the marijuana market, I'm willing to spread my risk around, which also most likely means that I will miss out on huge upward spikes in the few of the hundreds of companies that makes it really big.

As can be seen below, MJ holdings continue to shift based on market conditions as professional managers decide the best way forward for the fund. Two months ago, Canopy (OTC:CGC), Cronos (OTC:CRON) and Tilray (TLRY) made up the top three holdings of roughly 29% whereas today the largest holdings are Aurora (OTC:ACB), GW Pharm (GWPH) and Cronos. Its no surprise that CGC is getting a heavier weighting in the ETF as it appears to be the favorite in the pack - its projected to $CAD 1 billion in sales by 2021 or sooner. They also have $3.7 billion in cash and cash equivalents giving Canopy a good chance of getting in the S&P 500 as it meets the market cap, liquidity, and financial viability criteria.

Source: ETF

IPO ETFs to Consider

First Trust US Equity Opportunities ETF

In the IPO market, I have the same feelings as I do in the marijuana market - spread my risk and diversify. There are two main ETFs in the IPO (initial public offering) space; however, they are very different in their holdings and process. The First Trust US Equity Opportunities ETF (FPX) was established in 2006 and has $1.1 billion in assets under management (AUM). FPX holds positions in the 100 largest US firms with recent IPOs, weighted by market cap.

Stocks are purchased after the close on the 6th trading day and sold on the 1000th, for a holding period of almost four years. It largest current holding is PayPal Holdings Inc (PYPL). If a stock held in the portfolio merges with or is acquired by a mature company, the resulting entity remains in the index - this appears to be the main reason there are non-new companies in their portfolio like Hersey (HSY) and Verizon (VZ). In many ways, FPX is more of a growth ETF with an IPO component.


Renaissance IPO ETF

The second ETF investing in the IPO space is the Renaissance IPO ETF (IPO). They were established in 2013 and has AUM of $40.8 million. Compared to FPX, IPO holds smaller cap companies. In my opinion, IPO is the best way to play the IPO stock market if you want to diversify your risk but concentrate primarily on new IPO stocks. IPO adds a new company to its basket within 90 days (sometimes within a week of their IPO date) of listing and removes a company after two years of public trading.

A word of caution here - the ETF is relatively small and not as liquid as other ETFs you might have invested in. It also re-balances its portfolio every quarter. In this ETF, new companies do not have much time to shine and make the investor money. Expect volatility. Nothing goes straight up or down; the stock has seen over 34% return this year.

Current international holdings include SoftBank Corp, Xiaomi, and China Tower Corp. It has been discussed that the ETF will soon reflect IPOs of Slack, Uber, Pinterest and Airbnb.


Source: Yahoo

First Trust US Equity Opportunities and Renaissance IPO Performance Comparison

I'm hesitant to put these two on a chart together as they really are in different markets, but here it goes. In general, both FPX and IPO have tracked closely over the last three years; however, FPX has pulled ahead this year; I suspect that is mainly from its Paypal holdings.


Data by YCharts

Compared to the S&P 500, IPO has outpaced the S&P index. The S&P 500 SPDR is up 16.5% vs 34% for IPO.


Data by YCharts

As shown here, IPO ETF can have quite a lot of volatility especially when there is a large market sell off like we saw in late 2018. I expect this volatility to continue.


Daily Spreads

One key factor that investors need to watch especially with lower volume ETFs is the bid-ask spread. "Bid" is the price someone's willing to pay for an investment vehicle like an ETF at a specific point in time. "Ask" is the price someone's willing to offer for a sale. The amount by which the ask price exceeds the bid price is called the "bid-ask spread." An ETF usually trades close to its net asset value (NAV). With lower volume ETFs, bid-ask spreads may exist and these can eat into overall returns.

Shown below are the spread for IPO ETF which are trending towards zero which is a positive event.


Comparison to 2000

Early in 2019, Renaissance Capital believed there was a large backlog of IPOs do to the 2018 federal shutdown. Their watch list of over 225 private companies that are planning to go public in 2019 has a value of almost $700 billion. They believe that IPO listings could raise $100 billion in 2019, higher than the 2000 record of $96 billion.

While I continue to have concerns about the IPO market valuations and lack of profits in many cases, some in the industry do not see it as a problem and do not see a correlation to the 2000 market. According to Jason Draho, head of UBS Asset Allocation, he stated: "While there are legitimate concerns about high valuations and earnings potential for some companies, these are not dot-com IPOs. The unicorns that could go public today are larger, older and more established than those early internet companies, attributes which have historically correlated with better long-term returns."


I am going to add a small holding of the IPO ETF in the near future. I would like to see a pullback to get in, but we might not see one that is too significant in the longer run. A word of caution here - the ETF is relatively small and not as liquid as other ETFs you might have invested in. It also re-balances its portfolio every quarter. In this ETF, new companies do not have much time to shine and make the investor money. Expect volatility. Nothing goes straight up or down; the stock has seen an over 34% return this year.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in IPO over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article is intended to provide educational information to readers and in no way constitutes investment advice. Investing in public securities is speculative and involves risk, including possible loss of principal. The reader of this article must determine whether or not any investments mentioned in this article are suitable for their portfolio, risk tolerance, and accepts responsibility for their decisions. Neither information nor any opinion expressed in this article constitutes a solicitation, an offer or a recommendation to buy, sell, or dispose of any investment or to provide any investment advice or service. An opinion in this article can change at any time without notice.

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