By Ashley Lau
NEW YORK, Oct 9 (Reuters) - While active mutual fund managers get in line early for hot initial public offerings (IPOs), their counterparts at exchange-traded funds often sit on the sidelines and wait days, if not months, before joining the action.
That is because most index-tracking ETFs need to wait for an IPO stock to be added to an underlying benchmark before the fund can add the company. That delay can cost some ETFs money because many IPOs get a first-day pop in price.
That has not stopped ETF providers, the latest being Renaissance Capital, from creating funds that invest in the IPO market, where ETFs tracking new public stocks have had a strong run this year.
The First Trust US IPO Index ETF, for example, rose 36 percent this year, while the Global X Social Media ETF , which includes recent IPOs Facebook Inc, LinkedIn Corp, Groupon Inc and plans to add Twitter, rose as much as 58 percent this year.
Renaissance Capital, the Greenwich, Connecticut-based firm that focuses on IPOs and has mutual funds that concentrate on the market, plans launch its first ETF later this year.
ETFs are usually passive and track a basket of securities in an index. That means they must wait at least five or six days for a stock to be added to an underlying index before the new holding can be added to a portfolio.
Most people think about IPO investing as buying a fund on its first day of trading and then benefiting from the performance pop that often follows, said Ryan Issakainen, an ETF strategist at Wheaton, Illinois-based First Trust, which manages a $176 million ETF focused on IPO stocks.
Instead, ETF providers pitch their funds as targeting the new-to-market discovery period of an IPO stock - after the price settles and before it is fully integrated into the broader market. The shelf-life of a single holding in the expected Renaissance ETF, therefore, will be capped at two years, with older IPOs removed during quarterly rebalances. The First Trust ETF has a roughly four-year cap for stocks in its fund.
ETFs COMING TO MARKET
The use of ETFs for exposure to the IPO market is still in early days, industry observers say, just as the $2 trillion ETF market is still relatively young, dating back to 1993 with the launch of the first ETF.
The First Trust ETF was the first to come to market in 2006 with an narrow focus on IPO stocks, while others, such as the Global X Social Media ETF, target niche segments of investing that largely reflect the IPO market.
Renaissance Capital's new ETF will track its benchmark Renaissance IPO Index, according to a May company filing with the Securities and Exchange Commission. It is expected to have an expense ratio of 60 basis points, roughly a fourth of the cost of its mutual fund cousin, the Renaissance IPO Plus Aftermarket Fund, which has an expense ratio of 2.5 percent.
The chief difference between the IPO mutual fund and the expected ETF, is that the mutual fund is actively managed and can include shares purchased when the company goes public, said Renaissance Principal Kathy Smith.
In an actively managed mutual fund, a manager can select stocks and request IPO shares ahead of time to build positions, instead of passively tracking an index.
That means that many ETFs miss any initial gains from the first day of trading. The 7,706 companies that went public between 1980 and 2012 jumped an average 17.9 percent on day one, according to research by Jay Ritter, a finance professor at the University of Florida who has tracked IPOs.
Many index providers have fast entry rules in place that determine when a new IPO stock can be added to an index, typically five or six days. Even once an index adds a stock, some ETFs, such as First Trust, wait until their fund's quarterly rebalancing period, which can sometimes be months later.
First Trust did not add Facebook until September, roughly four months after the stock's debut.
"It worked out quite well for investors because at the time it was trading in the low $20's," Issakainen said, below the stock's IPO price of $38.
Facebook shares were up at more than $50 a share on the Nasdaq this week.
ETFs such as the Global X Social Media fund see benefits to the delay because it allows time for a stock price to settle after the initial excitement around the market debut.
"We would wait a few days to let the process of price discovery take place," said Bruno del Ama, chief executive of New York-based Global X Funds, which waited several days before adding Facebook to its ETF, and plans to do the same for Twitter.
Still, the time lag for these ETFs adding IPO stocks is much quicker than traditional indexes. It took about 19 months for Google to join the S&P 500 index. Companies such Facebook and LinkedIn have yet to join the benchmark index.