Make Millions Trading Stocks: How to Play Hot Tech IPOs With ETFs

Saturday, October 22, 2016

How to Play Hot Tech IPOs With ETFs

After a slow start to the year, global technology IPOs made a smashing comeback last month. 32 technology companies made their public debut—making it the most active September for tech IPOs since the tech bubble era. These companies raised $4.3 billion--42% of total volume in 2016 and the second biggest September volume on record, per Dealogic.

Tech unicorn (private company valued more than $1 billion) Nutanix (NTNX) surged 131% on its debut—biggest first day pop for 2016. Another unicorn—Twilio (TWLO)—had soared more than 90% on the first day of trading. Coupa Software (COUP) surged more than 100% on the opening day.

Acacia Communications (ACIA) is the best performing IPO this year, up 272% since its debut in May. Tech IPOs were up on average 72% from their offer prices, while IPOs across all sectors this year had an average return of 35% as of September 30. (Read:Prepare for a Clinton Presidency with These Stocks & ETFs)

While Twilio and Nutanix were arguably the most-high profile IPOs, the largest offerings this year were made by foreign tech companies. Denmark’s Nets which raised $2.4 billion in September, is the largest tech IPO globally this year. Another IPO exceeding $1 billion--Japan’s messaging app company LINE--is listed on the NYSE as well in Tokyo.

According to a WSJ report, the parent of Snapchat may launch its IPO early next year. The messaging app company could raise $25 billion or more, making it the biggest IPO since 2014 when Alibaba raised $168 billion.

There are many who believe that Snapchat is used mainly by teenagers for sexting but the truth is most users are in the 18-24 age bracket, followed by 25-34. The maturing of the user demographic has made advertisers more enthusiastic about the app.

Unlike rival Twitter, the messaging app company which has started experimenting with hardware has seen strong growth in users and revenues as it continues to innovate. (Read: Is Samsung’s Pain Apple’s Gain: ETFs in Focus)

Other mega unicorns such as Uber, Airbnb and Palantir haven’t announced any plans so far as they have been raising private money at attractive rates.
And remaining private helps them avoid intense public scrutiny.

There are other very high profile US companies that are expected to go public next year. EY expects “very robust” IPO market in 2017, because of a backlog. Many start-ups have put their IPO plans on hold this year due to monetary policy and geopolitical uncertainty. (Read: Will Tech ETFs Continue Their Rally in Q3 Earnings)

“However, as the political situation becomes clearer, the mix of a steady economic backdrop, accommodative monetary policy, low-interest rate environments, still high equity valuations and current low volatility levels are expected to lead to a rebound in IPO activity,” per EY.

Case for Investing in IPO ETFs

Remember, not all IPOs are successful. Investing in smaller, rather unknown companies can be quite risky. While a handful of these fledgling companies may turn out to be excellent investments, some may result in big losses.

Using an ETF approach is a low-risk and convenient way of getting exposure to this ‘hot” corner of the investing world.

IPO ETFs provide exposure to newly public companies before they join other core US equity indexes. Most broad market indexes include newly public companies only after a ‘seasoning’ period—i.e. after they have been trading for some time. For example, Google was included in the S&P 500 index about two years after its debut.

Investors should however note that they will not be able to capture the first day’s ‘pop’ (or drop!) with these ETFs, since they include the newly public stock only after it has been trading for a few days.

While it is true that some IPOs surge in value on the first day but, first day’s pop appears to be no guarantee for the IPO’s success in future. Many IPOs do not really shine on the first day but deliver much better performance later, as we can see from the table of five best performing US IPOs this year (Source: IPOscoop.com)

And many IPOs surge on the first day but sink later. The table below shows the performance of five worst performing IPOs.

Many investors probably still remember the disastrous performance of some of the ‘hot’ IPOs from the dot-com era. An ETF approach can largely reduce the risks, while offering the opportunity to participate in the gains of a diversified group of larger, more liquid IPOs.

First Trust US IPO Index (FPX)

FPX tracks the IPOX-100 U.S. Index, which is a modified value-weighted price index measuring the performance of 100 largest, typically best performing and most liquid U.S. IPOs (including spin-offs).

Currently, the product is dominated by Technology (29% of assets) and Healthcare (20%) sectors while Kraft Heinz (KHC), AbbVie (ABBV) and Facebook (FB - Free Report)take the top three spots.

With a 10% cap on all constituents, the fund rules out too much concentration in any single holding. The ETF, which was initiated in 2006, has managed to attract about $561 million in assets so far. Looking at the longer-term performance, the product has beaten the broader market since inception, with a return of 11% versus 7.4% return for the S&P 500 index during the same period.

Renaissance IPO ETF (IPO)

IPO tracks the rules-based Renaissance IPO Index which is comprised of the largest and most liquid newly-listed U.S. IPOs. New companies are included in the index on the fifth day of trading or during quarterly review. They are removed after two years.

Alibaba (BABA - Free Report) is currently the largest holding with 10.6% of the assets, followed Citizens Financial (CFG) and Axalta Coating (AXTA) at 10.2% and 6.2% respectively. Like FPX, the individual holdings are capped at 10%.

From a sector perspective, technology stocks (24.2%) take the top spot, while financials (17.9%), and Consumer Services (16.6%) round out the top three.

The product is much newer compared to FPX (launched in October 2013); since inception it has underperformed the S&P 500 index, with a 4.9% return versus 32.1% return for SPY during the same period.

FPX vs. IPO: How do They Compare?

While both the products provide access to newly minted public companies, they are quite different in terms of holdings. While FPX holds stocks for four years and includes spin-offs, IPO holds stocks only for two years. Neither of them provides access to shares before the public debut or to first day “pop”.

FPX has clearly been a winner in terms of performance as well as popularity. Both charge 60 basis points for annual expenses.