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Early Bird Gets the Runup

Illustration by
Vasily Kafanov

The IPOX IPO Indexes Rationale

Global issuing activity in initial public offerings (IPOs) has picked up, associated with a large increase in filings of well-branded U.S. companies in a broad range of industries. This is being driving by the favorable performance of recently issued IPOs and fundamental shifts in the profile of U.S. IPO companies following Sarbanes-Oxley, safeguarding higher-quality listing standards and severe regulatory scrutiny towards IPO companies. As a result, a large number of older and more mature companies have been going public (Figure 1 and 2).

For investors, the importance of having timely expusure to IPOs has been widely recognized.  Russell, for example, recently decided to add IPOs to their indexes on a quarterly and not just an annual basis.

The importance of having timely exposure has been widely recognized. Russell Indexes, for example, recently decided to add IPOs to their indexes on a quarterly and not just an annual basis.

IPOX IPO Indexes are the first series of "investable" index products capturing the large universe of U.S. IPOs (IPOX Composite Index) and the respective size indexes (IPOX-100 and IPOX-30 Indexes). These indexes provide market participants with the opportunity to track the long-run aftermarket performance of the U.S. IPO sector more accurately and comprehensively thean ever before.

The underlying rational behind the IPOX Indexes is the need to classify IPOs from the rest of the market because IPOs bear unique empirical return dynamics up to at least four years after the 'going public' event. In other words, the 'going public' has an impact on the fundamental development of a company far beyond the price fluctuations in the immediate aftermarket. IPOX Indexes accomplish the systematic indexing of the long-run aftermarket performance of the U.S. IPO sector, while at the same time preserving the benefits of diversification via "average IPO investing" or "IPO indexation." Because of the dynamic nature of the profile of the average IPOX constituent ¾ typically a true reflection of the growth and innovativeness of the U.S. economy and equity capital markets trends ¾ IPOX Indexes do not make a defined distinction between sector, size or style.

Why Are IPOs Unique? The Academic Perspective

A large body of academic literature has focused on the IPO sector, identifying a number of empirical patterns unique to IPOs. One such pattern concerns the existence of abnormal initial returns, whereby the first market price is on average significantly higher than the offering price. Ritter and Welch (2002) find an average first-day return of 18.8% of 6,240 U.S. IPOs between 1980 and 2001. They focus on conflicts of interests within the investment banking industry, which potentially influence IPO initial returns and the dynamics in aftermarket trading.

Another pattern associated with IPOs relates to the observation of significant, recurrent and to some extent predictable variations in IPO issuing activity over time. Ritter (1984) studies initial returns for U.S. IPOs and finds highly significant autocorrelation in monthly average initial returns and IPO volume. Lowry and Schwert (2002) confirm a significantly positive relation between initial returns and future IPO volume and note … "increased numbers of companies go public after observing that IPOs are underpriced by the greatest amount."

Most of the empirical IPO studies concentrate on the IPO return dynamics in short- and long-run aftermarket trading. While the conventional view was that IPOs underperform in the long-run (Ritter (1991), it has become apparent that the performance results are sensitive to the time period chosen and the applied methodology (Gompers and Lerner (2001). This notion is underlined in Schuster (2003), who highlights large cross-sectional differences in the long-run performance of European IPOs and rejects the notion of long-run underperformance.

A related facet in the IPO aftermarket performance debate addresses the relation between short- and long-run IPO returns. One of the first to document these dynamics was Stoll and Curley (1970) who found considerable benchmark-adjusted IPO short-run overperformance while reporting significant long-run underperformance. Considerable short-run overperformance in U.S. IPOs is also reported in Ritter (1991). Miller (1977) explains these price dynamics within a semi-rational setting. The "divergence of opinion" about a new issue is greatest when the stock is issued, because there is uncertainty about the success of new products or the profitability of a major business expansion. As a result, short-sale constraints can lead to upward biases in stock prices. As a company acquires an earnings history, the marginal investor's valuation will converge towards the mean valuation and IPOs will start to underperform. Duffie, Gârleanu and Pederson (2002) show that, if lendable securities are difficult to locate, then the price of an IPO security is expected to decline over time.

Teoh, Welch and Wong (1998) relate the analysis of IPO performance to earnings management. They find a negative relation between long-run IPO performance and the degree to which managers boost their earnings during the IPO year. Luo and Schuster (2003) show dramatic short-run overperformance of IPO companies in Germany that aggressively manage their earnings during the IPO year, underlying the notion that the returns of IPO companies during their first six months on the market are essentially driven by factors other than fundamentals.

A number of other institutional arrangements unique to IPOs can have an effect on prices. Lock-up agreements, for example, prohibit insider sales before a specified date. Since insiders often own a majority of the firm, the potential for an increase in the supply of tradable shares following lock-up expiration can have a significant effect on the value of the stock (Bradley, Jordan, Roten and Yi (2001), Brav and Gompers (2002) and Field and Hanka (2001). Bradley , Jordan and Ritter (2002) also find abnormal returns in the days before the expiration of the "quiet period." Furthermore, Aggarwal (2000) finds that "pure" stabilization, in which an identified bid is posted, is never done, while aftermarket short-covering, which has no disclosure requirements, is the principal form of underwriter price support. Stabilization by short-covering can occur because the underwriter initially sells shares in excess of the original amount offered, which is then covered by exercising the overallottment option and/or by short-covering in the aftermarket during the 30 days after the offering.

The IPOX Composite Index is a rules-based index and provides the basis for the IPOX-100 and IPOX-30 Indexes (Table 1). It is a value-weighted, all-cap momentum index, which measures the performance of IPOs in calendar time. The IPOX Composite Index is dynamically reconstituted: IPOs enter at their seventh trading day after 'going public,' and automatically exit after 1,000 trading days or four years on the stock market. Because IPO activity fluctuates over time, the number of securities in the IPOX Composite Index fluctuates accordingly. The IPOX Composite Index includes constituents from a broad mix of industries, including large, mature IPO companies and fast-growing and successful IPOs, as well as IPOs underperforming the market. As of September 30 , 2004, the index pooled around $480 billion worth of U.S. stock market capitalization and between 7% and15% of total daily trading volume on the U.S. exchanges, with a total market capitalization range of approximately $4 million to $54 billion. Only U.S.-domiciled companies that meet minimum qualitative entrance requirements based on size, adjusted float and initial pricing trading on NYSE, NASDAQ or AMEX are eligible for index membership.

The IPOX-100 and IPOX-30 measure the performance of the Top 100 and Top 30 ¾ representing around 85% and 50% of total market capitalization respectively ¾ in the IPOX Composite Index. The IPOX-100 and IPOX-30 typically include the largest, most liquid and best performing IPOs in the IPOX-Composite Index. With its fixed number of constituent stocks, the IPOX-100 Index currently pools around $381bn and the IPOX-30 around $289 billion worth of U.S. stock market capitalization. Unlike the IPOX-Composite Index, the IPOX-100 and IPOX-30 are reconstituted quarterly to reflect changes in stock market values of IPOX Composite Index constituents and IPO activity during the previous quarter. In order to maintain diversification rules, the IPOX-100 and IPOX-30 apply a modified-capitalization rule, whereby the influence of the largest index constituents in the IPOX-100 and IPOX-30 Index is capped at 10% at the quarterly reconstitution event.

IPOX Indexes Analytics And Historical Performance

The performance of the IPOX Indexes indicates the benefit of a systematic exposure in the IPOX-100 and IPOX-30 relative to the major U.S. equity indexes (Figure 3).

More fundamentally, the decreasing difference in performance between the IPOX Composite and the IPOX-100 and IPOX-30 in recent years underlines the increasingly favorable performance of the average IPOX Composite constituent, a likely outcome from the increased regulatory scrutiny towards IPOs during the past few years.

The analysis of one-year correlation coefficients (Table 2) clearly indicates the distinctive character and dynamics of the IPOX Indexes. Historically, IPO activity has been closely associated with the high-risk, high-return profile of companies in NASDAQ. The decrease in dominance of high-tech IPOs indicated by an insignificant correlation of the IPOX-30 Index against the NASDAQ Composite index during the past twelve months is setting this IPOX Composite subset clearly apart from the rest of the index universe. This also underlines the impact of fundamental changes associated with Sarbanes-Oxley affecting the profile of the average IPOX constituent.

IPOX Indexes: Designed For Various Market Participants

The IPOX Indexes are all-cap momentum indexes that provide an alternative way to make sector, size and style decisions in equities. The IPOX-100 and IPOX-30 pool the largest and outperforming U.S. IPOs in the IPOX Composite Index into a liquid, separately tradable equity sector with unique empirical features and favorable historical performance against the major equity indexes and provide average, rather than median exposure to the long-run aftermarket performance of IPOs.

The underlying empirical features in IPOs make products benchmarked against the IPOX Indexes interesting for a number of market participants with varying investment horizons, such as active index managers, index spreaders, basket traders or the retail buy-and-hold return community.

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