Don’t Chase Alibaba Or Anything With An ETF

Why smart investors ignore headlines.

Why smart investors ignore headlines.

It’s extremely tempting to make every story an ETF story. After all, there are now ETFs that cover virtually every corner of the investing universe. The two-week marketing blitz by Alibaba has made this even more tempting.

Virtually every call I’ve fielded from reporters in the last two weeks has included the question “What does BABA mean for ETFs?”

Look, I get it. It’s the story of the day. And of course, we did the deep, deep dive on exactly where and when BABA will show up in ETF-land. It’s an interesting story, but honestly, it’s deep wonkery.

Yes, it’s curious that BABA won’t even end up in tech funds that rely on the Standard. And because it’s a New York-listed Chinese company, it slips through the cracks in the MSCI methodology and won’t end up anywhere until the rules change.

But let’s be honest, as an investor, these facts should be irrelevant. I have nothing against Alibaba, or initial public offerings. It’s a giant company with a real business, and one assumes that, by going IPO, they’ll be able to raise additional capital to do more awesome things. It’s capitalism at its purest, and I’m all for it.

But I’m not generally a fan of single-stock risk in a portfolio, and I’m really not a fan of IPO risk in a portfolio.

The IPO Problem

A lot of people are going to trade Alibaba tomorrow. A lot. The vast majority of those people will not be investing. They’ll be gambling. The IPO will “price” at something like $68 a share. The question then becomes “So what?”

All the folks getting allocations at that price will have free rein to sell it. So will roughly $8 billion in insider holdings that are not part of the IPO allocation. That’s nearly one-third the value of the shares already being dumped into the market through allocations.

In other words, that’s a lot of sellers. To drum up demand, Alibaba has been on a roadshow, and working the phones. They want a marketplace frothy and full of speculators to at the very least keep the IPO trading around its initial price, or ideally, to run up ridiculously like they did in the late ’90s.

The jockeying to get in is understandable. If anyone has the axe on IPO data, it’s Professor Jay Ritter at the University of Florida. His website has more data on global IPOs than you can find anywhere else. But all you really need to know is that yes, on average, IPOs close on their first day well above their initial prices.

Popping Prices

In 2013, the average of the 161 IPOs popped 21 percent on the first day. Even in the worst IPO year in my lifetime, 2008, the 21 IPOs popped an average of 6.4 percent.

That sounds like free money, right? The problem is, unless you were literally just handed shares at the IPO price, it’s very difficult to book that gain. Instead, most investors end up piling into the hype, while insider, friends and family pick their dumping prices.

It’s for this reason that even the most IPO-happy ETF, the Renaissance IPO ETF (IPO | F-34), waits until an IPO has traded for five days before admitting a new issue. Most broader, well-known indexes have a minimum of a 90-day seasoning period. This removes the risk that you get caught on the wrong end of the IPO pop, and also makes sure that there’s not a guaranteed buyer in the market for the stock to match with the guaranteed sellers (the insiders).

So if you want to plow into the Renaissance IPO ETF, that’s great, but recognize that it’s just going into the open market to buy shares next week, just like you could in your Schwab account.

The Apple Problem

So the short answer of how to play BABA with an ETF is “you can’t,” and that’s probably a good thing. If you want to “play” BABA, recognize that you’re gambling, speculating or day trading, whatever you choose to call it, and best of luck to you.

But the other big thing I get calls about is “how to play Apple with an ETF.” These calls generally come in whenever Apple makes an earnings announcement, or whenever they take the stage to hype their new product.

And the answer is really exactly the same as it is for Alibaba—you really shouldn’t.

I don’t mean you should ignore what your ETF holds. On the contrary, I think you should absolutely know exactly what your ETF holds. And if you’re an investor in, say, the Technology Select Sector SPDR (XLK | A-78), then you certainly should understand you’ve got 16 percent of your money in Apple, and be comfortable with that.

But I believe most investors are better off focusing on risk management and diversification than in making sure their stock portfolio is positioned for a specific announcement.

The whole premise of indexing is to control your costs, minimize trading and create easy diversification. The point of diversification is mitigating single-stock risk and capturing broad economic performance.

So by all means, grab the popcorn and watch the chaos that will be the opening bell tomorrow. But hopefully, do it knowing that your ETF portfolio will carry on in the background, blissfully ignorant of the headlines.

At the time this article was written, the author held no positions in the securities mentioned, and hasn’t bought an IPO since the ’90s. You can reach Dave Nadig at [email protected], or on Twitter @DaveNadig.