- The IPO ETF invests in companies that launched an initial public offering within the last few years.
- While 2020 was a big year for IPOs, the segment has underperformed more recently with significant volatility amid macro-dynamics.
- Despite shortcomings to the fund structure, IPO's unique exposure makes it a good option to capture tactical trends in high-growth tech stocks.
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The Renaissance IPO ETF (NYSEARCA:IPO) invests in companies that recently began trading following an initial public offering. The attraction in IPOs is the typical early-stage growth profile of the companies with an innovative product or service that has the potential to generate significant returns. While 2020 was a particularly strong year for IPOs emerging out of the pandemic, the momentum has changed with more bearish sentiment towards the group. Indeed, IPO has underperformed this year, highlighting some weaknesses in the strategy and fund structure amid broader market headwinds. While we expect volatility to continue, we see value in the fund given its unique exposure as a contrarian idea in a group of beaten-down stocks.
IPO ETF Background
IPO technically tracks the "FTSE Renaissance IPO Index" considering companies that began trading within the last three years. The largest 80% of IPOs by market cap are eligible for inclusion which means some stocks may begin trading, but only enter the fund a year or two later, after it grows in size. Similarly, underperforming holdings that fall out of that top 80% of the investing universe are removed from the fund. Stocks are no longer deemed eligible after approximately two years from their IPO date, at which point they become "seasoned equities" according to the fund manager all of which is determined through a quarterly rebalancing.
The result is an exceptionally high turnover of over 100% which means the entire portfolio changes on an annual basis with some stocks only included for a few quarters. Eligible IPOs must have a market value of at least $100 million within the first year of trading and maintain a minimum free-float threshold of at least 5%. Constituents are also weighted by float-adjusted market capitalizations. Finally, it's worth noting that special purpose acquisition companies "SPACs" are excluded.
Approximately 50% of the holdings are categorized as in the tech sector, although there is some grey area here considering "fintech" names and biotech stocks capture similar high-level themes suggesting the majority of the fund tilts towards technology.
(source: Renaissance Capital)
The current portfolio includes 107 holdings with 88% of the allocations towards large-cap companies considering a market cap above $10 billion. The largest holdings are Moderna Inc (MRNA) with an 8.1% weighting, followed by Snowflake Inc (SNOW) at 6.4%, and Uber Technologies Inc (UBER) at 6.1%. For context, Moderna Inc began trading in December of 2018 meaning it is approaching its 3-year cutoff.
(source: Renaissance Capital)
Indeed, just within the top-10 holdings, we note that several companies including Uber, Cloudflare Inc (NET), Zoom Video Communications Inc (ZM), CrowdStrike Holdings Inc (CRWD), Datadog Inc (DDOG), and BioNTech (BNTX) all began trading back in 2019, meaning they are all on track to be excluded from the fund by the end of next year.
Weakness Of The IPO ETF Structure
One of the challenges that the extreme level of portfolio turnover creates is that investors are largely blind to the composition of the fund from quarter to quarter. The understanding is that the intended exposure is in "IPOs" as a market segment, but on that point, it's a stretch to call some of these stocks that have been trading for nearly three years "new companies".
There is also some ambiguity regarding the actual quarterly rebalancing and stock screening process. Even Moderna, which has had a spectacular year in 2021 returning nearly 200%, has gone in and out of the fund. It's recorded that Moderna was removed from IPO in December of 2020 before re-entering just this past September. From the top-10 holdings; Uber, Zoom Video, Crowdstrike which are in the "2019 vintage" were all deleted in June 2021 and curiously came back as an addition just three months later in the last quarter.
It follows that these types of seemingly random portfolio changes, even if consistent with the rules-based methodology, end up being detrimental to the performance against more orthodox portfolio management buy-and-hold techniques. It also creates a problem when attempting to attribute the fund's performance to specific underlying holdings over different time frames.
Finally, we note that the academic evidence and empirical data on the performance of "IPO stocks" are mixed. Based on a study of 8,610 IPOs between 1980 and 2019 collected by finance professor Jay Ritter from the University of Florida, the average first-day performance of IPOs from the offering price is an impressive 17.9%. On the other hand, the data also finds that the group ends up underperforming the market by an average of 15.8% over 3 years with a buy-and-hold strategy. When the performance is adjusted for style factors like "value" and "growth", the underperformance is smaller but still a negative -5.2%. In other words, the first-day trading spike is critical for capturing the value in IPOs.
(Source: Jay Ritter U of Florida)
This is concerning for the IPO ETF, particularly because it adds stocks after they have been trading for several months or until the size eligibility. In other words, it's unclear if the strategy generates real alpha. The conclusion from the report is that while insiders and investors receiving an allocation of shares at the offering price are winners in IPOs, buying IPO stocks after the offering is often a losing strategy.
IPO ETF Mixed Performance
With a fund inception date in October 2013, IPO has cumulatively returned 202%. This compares to a 207% gain in the SPDR S&P 500 ETF (SPY) and 424% return by the Invesco QQQ ETF (QQQ) which tracks the NASDAQ-100. From the chart below, it's evident that the fund was lagging significantly between 2014 and early 2020 before a spectacular rally off the pandemic lows. In the calendar year 2020, IPO was a big winner returning 107% consistent with its exposure to high-growth tech stocks.
The fortunes have reversed with IPO down around 9% this year compared to a 24% return in QQQ and 22% from SPY. One of the headwinds has been broader market volatility this year with more speculative-momentum type names selling off since Q1 with the market rebalancing into the emerging post-pandemic recovery.
The market this year has tended to gravitate towards high-quality blue-chip leaders while the sentiment towards emerging companies soured with a greater focus on valuations which likely reached extreme levels at the highs for this group. Going back to the IPO fund holdings, with the exceptions of Datadog Inc, all of the top-10 positions are down by more than 20% from their 52-week high, effectively in a bear market.
To be clear, the fund has 107 different stocks and some exceptions have been able to breakthrough. Notably, grocery store chain Albertsons Inc (ACI), for example, with a 0.6% weighting in the fund is up 96% in 2021. Overall, it paints a difficult picture regarding not only the changing market environment but also the high-risk profile of the fund
To conclude, IPOs have been disappointing in 2021 exhibiting extreme volatility. New headwinds including renewed Covid disruptions with the Omicron variant along with uncertainties related to recurring inflation and Fed policy should continue to keep this segment of stocks volatile.
Despite the fund's shortcomings, taking a glass-half-full approach, we see value in the IPO ETF based on its specific exposure as a tactical trading instrument. In periods where high-growth, high-valuation type tech names gain momentum, the IPO ETF can outperform with significant upside. In the context of a diversified portfolio, the IPO ETF can also work as a diversifier considering its holdings include many stocks that are otherwise not widely held or included in broad market indexes. In the current market environment, we can consider IPO as a contrarian idea with an expectation that many of the holdings will ultimately rebound and deliver positive returns.
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This article was written by
15 years of professional experience in capital markets and investment management at major financial institutions.
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Analyst’s Disclosure: I/we have a beneficial long position in the shares of ZM either through stock ownership, options, or other derivatives. 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.
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