How To Cash In On IPOs And Spin-Offs Via ETFs

Why always hold the safe, blue chip companies from one decade to the next when you can cash in on new and exciting entrants to the market?

The initial public offering (IPO) and spin-off indexes from U.S.-based IPOX offers investors that exposure – an array, in fact, of applied market cap weighted indexes which are adjusted for equity turnover – and which track a number of new companies on stock exchanges around the world.

First Trust launched the first ETF in Europe in April to replicate this kind of U.S. equity market activity. It also happens to be First Trust’s non-AlphaDEX fund in the region.

The provider’s relationship with IPOX goes back to April 2006, when it brought to market the U.S.-listed First Trust US IPO Index Fund ETF (FPX), which is up 21 percent in five years, compared to the SPDR S&P 500 ETF Trust ETF (SPY)’s 14 percent returns over the same period.

The outlook for the index looks promising. Year to date there have been around 560 companies going public on a global level, and Josef Schuster, founder and director of IPOX Schuster LLC, anticipates 150 to 200 more by the end of 2015.

ETF.com Europe speaks to Schuster to find out more about investing in the unknown and what IPOs and spin-offs mean about economic strength.

ETF.com: What does IPO activity indicate about the health of an economy?

Josef Schuster: Well, if you assume that an IPO acts as a catalyst for a company going public, an IPO is an important function of the economy and of equity capital markets in the U.S. and Europe. IPOs are indicative of a pretty strong economy.

We’ve had lots of inflows in the U.S. Last year there were over 200 deals globally, and there are 200 plus deals year to date – to some degree there’s a correlation between economic and IPO activity. There’s underlying correlation between job market growth and IPO activity too, as typically companies hire when they go public.

ETF.com: How do you measure an IPO exactly?

Schuster: We measure IPOs and spin-offs and we pool these two asset classes together into one tradable equity sector, and then we design an innovative index technology around it – we hold these companies for a certain period of time after they start trading then we rotate companies out automatically when we believe the “going public effect” is no longer there. If you want, it’s a semi-passive approach to new deal flow.

We track companies from the sixth day of trading up to the 1000^th trading day. Then we rotate companies out of the portfolio. It’s very different to the likes of S&P, Russell, MSCI or NASDAQ in the sense that we believe the going public effect is a long-term one but it terminates at some point in the “aftermarket”. We get rid of stocks, we don’t hold onto IBM or Facebook forever – we have a termination date. This makes things different and it’s upside down compared to the main index providers.

ETF.com: Why do you start tracking companies on the sixth day?

Schuster: We’re not interested in the short term hype in the IPO market when there there’s a lot of buying going on and volatility in the first few days. We wrote the rule book 12 years ago and we decided we are more interested in the first four years. The IPOX 100 index rebalances quarterly so we may not buy a company on its sixth day, it might be later, depending on when the rebalancing date falls.

ETF.com: Do any particular IPOs stick in your mind?

Schuster: Obviously we have had our share of winners and losers. The index is market cap weighted so we have had good exposure to the largest deals respectively over the years, to CME group in 2002, then Alcon out of Switzerland the same year; systematic exposure continued to companies like Google in 2004 and Philip Morris in 2008. More recently, we are fortunate to have Facebook and other momentum-type companies in the index. Other IPOs turn out to be more value-type stocks.

But we are agnostic to what is in the portfolio. The goal is to track deal flow. And on average if you have a basket of many stocks it gives you diversified exposure to momentum and growth stocks.

ETF.com: Is there ever a danger that you don’t have enough companies to track during a period of low IPO activity?

Schuster: We have back tested the index since 1975 and it has always worked in the U.S. with a substantial deal flow underneath. If there was no deal flow for one, two or three years, we would extend the company holding period or move to an index which was more concentrated like the IPOX 30. We do have these extreme scenarios but even in 2008 we had 40 companies going public.

In the European market it’s a bit different. We have had times in 2009, 2010 and 2011 where we had very little deal flow and we extended the holding period for companies. So we do have actual experience of managing those scenarios, but they are unlikely to happen in the U.S.: it’s such a big and fertile space of equity market activity, even during a bad period.

ETF.com: Would you agree this index requires a bit more faith from the investor, as it gets rid of the big, safe blue chips? It’s like investing in the unknown.

Schuster: It is obviously going into the unknown: it’s systematic exposure and there is some structural risk too in that you don’t know what the deal flow will look like in four or five years and by default the index will be different by that point too. But it allows exposure to a risk factor they otherwise don’t get.

IPO activity presents the innovative drivers of an economy which is always underweight in the main indexes and overweight in our indexes. We believe there’s an asset allocation benefit here and the performance speaks for itself on a risk-adjusted basis, and it’s all based on academic work I did in London 12 years ago.

ETF.com: The European index is more concentrated in financials and has half the number of holdings (50 companies) – is that reflective of limited IPO activity?

Schuster: We believe there’s a case to make room for international exposure [ex-U.S] as if you pool the U.S., China and Hong Kong together that’s not sustainable [too many names], so we picked 50 names for Europe alone. We think it’s a great complement to what we have in the U.S.

In the IPOX-50 Global index, there’s been a lot of deal flow coming from China with Alibaba and some large names are going public in Europe, including some private equity backed companies. And deal flow has also picked up in Germany.