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IPO and Social-Media ETFs Set to Welcome Twitter

Robert Goldsborough

It's been a terrific year so far for the United States stock market, but an even better year for U.S. initial public offerings, with IPO volume through the end of September already topping the total IPO volume for all of 2012. As Morningstar equity analyst Jim Krapfel recently noted, there have been 179 offerings versus 131 in 2012, and that also represented an increase from 2011. In fact, offerings are on pace with what took place from 2004 until 2007.

Into this environment comes what we believe is the most anticipated IPO since last year's listing of Facebook (FB): microblogging service Twitter (TWTR), which is set to price on Wednesday and begin trading on Thursday. Although Twitter lost money in 2012 and in the first six months of 2013, investors appear undeterred and remain enthusiastic about growth prospects for the company, which has 232 million active users around the globe posting some 500 million tweets each day.

Twitter is expected to go public as a mid-cap company, with a total market capitalization of somewhere above $15 billion. Its IPO will raise proceeds of as much as $1.75 billion. So assuming investors don't wildly reward Twitter immediately after it lists, the company still will be a small fry relative to Facebook, which has a market cap of more than $120 billion.

Still, Twitter's listing has attracted no shortage of headlines and is renewing investors' interest in the IPO market more broadly, particularly given that technology and biotechnology companies have dominated the IPO market in 2013. Tech and Internet IPOs have made up 35 of the 179 offerings this year, with health-care IPOs comprising another 45, according to Morningstar data. For exchange-traded fund investors, it seems an apt time to take a look at how to access Twitter through an ETF, what impact Twitter is expected to have on those funds' composition, and what options investors have for investing in IPOs.

First, however, a word about Twitter's fundamentals. Morningstar senior equity analyst Rick Summer has awarded Twitter a narrow Morningstar Economic Moat Rating and has concluded that the company only has started to begin monetizing its 232 million monthly active users. Summer expects Twitter to expand its user base and its monetization capabilities through new advertising products, and he envisions Twitter widening its narrow moat and enjoying benefits from its network effects and proprietary customer data set. He assigns Twitter a fair value estimate of $26, which is slightly above the current filing range of $23 to $25 per share. That suggests that Twitter is slightly undervalued and may well rally on its first day, assuming the offering doesn't end up pricing well above that range.

It's critical to understand that although ordinary investors may find the first-day gain to be the most appealing part of an IPO, ETF investors have no chance of enjoying that. In every case, newly issued securities require a certain amount of trading activity before being added to an ETF. So investors looking to enjoy the first-day "pop" in an IPO are better off finding a broker who can get them an allocation in Twitter's IPO out of the gate.

Here is a quick look at some of the ETFs expected to hold meaningful positions of Twitter, and when they will begin doing so:

First Trust US IPO Index (FPX)
This $240 million ETF effectively is a reflection of the IPO market for a rolling four-year period. FPX replicates an index of the 100 largest and most liquid companies that have gone public in the past 1,000 trading days, or about four years. Companies do not join the index until seven days after they begin trading, which means Twitter will trade for a while before becoming a part of FPX's index. There is a delay because the index provider is attempting to allow a newly listed company's trading to settle down a bit. FPX's portfolio is market-cap-weighted, and a holding's position is not based on its float-adjusted market cap but rather on its total market cap. Even so, Twitter likely will make up about 2% of this ETF--or just a fraction of the 11% that Facebook presently comprises (this index caps holdings at each rebalance at 10%). One final note: FPX has posted terrific performance over the past one-, three- and five-year periods, returning 48%, 26%, and 24%, respectively. The fund has handily bested broader benchmarks and has done a decent job tracking its index. Turnover has not been excessive (about 48% a year). FPX charges 0.60%.

Renaissance IPO ETF IPO (IPO)
Launched less than a month ago and still fairly thinly traded, this $28 million fund tracks a market-cap-weighted 50-stock index consisting of a rolling two-year population of the top 80% of newly public companies based on full market capitalization. However, the index assigns weights based on investable market capitalization. So we would expect Twitter to have a much smaller weight in this ETF. This fund also is expected to admit Twitter sooner than FPX, as its index permits the addition of newly listed firms on their fifth day of trading. We expect Twitter to make up just 1% or so of the index out of the gate. This ETF charges 0.60%.

Global X Social Media Index ETF(SOCL)
For those less interested in IPOs specifically and more interested in a basket of social-media companies, this fund really is the only game in town. The lone ETF that focuses solely on social-media firms, SOCL rolled out in 2011 with the expectation that Facebook and Twitter eventually would go public. Now with $96 million in assets, SOCL tracks a market-cap-weighted Solactive index of 28 social-media companies. Under the index's rules, Twitter would join after its fifth day of trading. Unlike the IPO ETFs, this fund tracks an index that weights constituents based on free-float market capitalization (although non-pure-play companies like Google (GOOG) are capped at 4.75% of the index upon each rebalancing). That means Twitter will make up a good bit more of this fund than of the IPO ETFs, probably about 10% out of the gate. (The index caps any one company at 10% of the index.) SOCL charges 0.65%.

First Trust Dow Jones Internet Index (FDN)
This is a very liquid $1.64 billion fund holding 40 companies that generate at least half of their revenues from the Internet. Don't expect to see Twitter in FDN for quite some time, however; the index that this fund attempts to replicate requires all constituents to have a minimum of three months' trading history. This ETF's index, the Dow Jones Internet Composite Index, also taps stocks based on float-adjusted market capitalization. So once Twitter enters FDN, it likely would be about a 1% position, based on its IPO range. FDN charges 0.60%.

PowerShares NASDAQ Internet Portfolio (PNQI)
This $216 million ETF tracks a Nasdaq index of Internet-related companies listed on any major U.S. stock exchange. PNQI requires a certain amount of seasoning for new stocks (a minimum of three months' trading), so Twitter is not likely to be added to this fund until the time of its index's next annual evaluation, which would be in March 2014. This ETF holds 82 companies and has a smaller-cap tilt. Assuming a share price that lands in the offer price range, Twitter likely will constitute 3% to 4% of PNQI. This ETF charges 0.60%.

Twitter's Impact on Large Tech ETFs
Twitter isn't expected to have much of an impact on the three largest U.S. technology ETFs, which are market-cap-weighted and have large positions in companies like Apple (AAPL). Based on index-construction rules for those three funds-- Technology Select Sector SPDR (XLK), iShares U.S. Technology ETF (IYW), and Vanguard Information Technology ETF (VGT)--when Twitter finally is included in their indexes, it likely would be far less than a 1.0% position based on the current offer range, probably something closer to 0.5%.

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Disclosure: Morningstar, Inc.’s Investment Management division licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index. Robert Goldsborough does not own shares in any of the securities mentioned above.