During the 1990s bull market, a crowd of fledging Internet companies soared and then crashed. Last year, Facebook's troubled launch served as a reminder that even strong companies can flop on their first day. In a recent study, T. Rowe Price tracked 4,500 companies that went public between 1995 and 2007. Of those that had less than $100 million in revenue on the first day of trading, only one out of 20 grew to $1 billion in revenue.
That history would seem to stack the odds against First Trust US IPO Index ETF . But the ETF has been delivering impressive results.
During the past five years, First Trust returned 9.8% annually, compared to 6.1% for the S&P 500, according to Morningstar. The fund appears to be succeeding because its index methodology systematically avoids some shaky start-ups and emphasizes IPOs with more staying power.
For starters, the index eliminates small companies, which can be prone to bankruptcy. In addition, the portfolio does not include any stocks that recorded dramatic rises or falls on the first day of trading. Stocks that stumble as they leave the starting block are prone to continue disappointing, says Ryan Issakainen, ETF strategist for First Trust Advisors. High flyers can also be dangerous. "If a stock shoots up 100% on the first day, then it could be too expensive," he says.
Of the companies that survive the initial screens, the index includes the 100 largest. The portfolio is rebalanced every quarter. Companies that drop below the top 100 rankings are eliminated and new stocks join. Holdings can stay in the index for up to 1,000 trading days, or about four years.
Because it emphasizes the biggest companies, the portfolio includes many familiar names with long track records. Among the top 10 holdings are General Motors , Kraft Foods and Hyatt Hotels .
Besides IPOs, the index can also include spinoffs. Those occur when a company sells or distributes a subsidiary. Stocks of spinoffs often perform well because newly independent managements cut costs and focus on core businesses.
The methodology of the fund is based on research by IPOX Schuster, which operates the index. According to the researchers, most new stocks lose money. During the period from 1996 through 2011, the median IPO lost 6.1% during its first 12 months. But stocks in the top quarter of the field did quite well. Those that ranked at the 25th percentile gained 39.1% in the first 12 months. Even though most IPOs lost money, it still paid to own the whole universe because the gains of the winners could compensate for the poor showing of also-rans. On average, the IPOs returned 15.1% during the first 12 months.
The researchers found that it paid to hold winners for about four years. Issakainen of First Trust says the strong performance may occur because of some common patterns in markets.
Many winning IPOs begin with low valuations. The shares may be cheap at first because they often receive little attention. Few analysts cover the new stocks, and the IPOs are not eligible to be included in broad benchmarks, such as the S&P 500.
Gradually Wall Street coverage increases. The stocks become better known, and the shares begin to rise. After some time, the stocks can be included in benchmarks. That provides a boost as index funds begin buying.
In a significant number of cases, stocks of the young companies surge after they become the targets of takeovers. IPOX Shuster says that since 2004, 12% of the members of its index have been merger targets. The interest trails off after 48 months, and the aging IPOs begin acting like other stocks.
Lately, the First Trust fund has benefited from a series of hot IPOs. The fund recorded big gains this year with electric car maker Tesla Motors and pipeline operator Kinder Morgan Energy Partners . During the past year, the fund returned 40.2%.
Seeing the big returns, you may be tempted to try your hand at picking IPOs. But keep in mind that the First Trust strategy differs from the approaches that investors often take. The fund never buys anything during an IPO's first week, a period when trading can be erratic. Because the portfolio only adds names once a quarter, most holdings have been trading for a month or longer before they are purchased. By that time the initial turbulence typically calms. In contrast, many investors aim to buy IPOs at the offering or on the first day of trading.
While many investors prefer small IPOs, First Trust favors giant issues. "The largest IPOs tend to give you the best risk-adjusted returns," says Issakainen.
This article was written by an independent contributor, separate from TheStreet's regular news coverage.