How to Profit from the Surprisingly Red-Hot IPO Market

Nicholas Vardy

2/20/2014 12:01:00 AM - Nicholas Vardy

For all of the hand wringing about the weak start to the stock market this year, initial public offerings (IPOs) haven't been this hot since 1999.

More than 30 companies have already launched IPOs in 2014. That is a 72% increase compared to the same time last year, according to Renaissance Capital, and the best start to the year for IPOs since at least 2006.

The popularity of investing in IPOs should be really no surprise.

After all, the share prices of IPOs -- driven in part by the boom in biotech -- are trouncing the broader market in terms of performance.

And, IPOs always offer all of the attractions of a lottery ticket, but with much better odds. If you're lucky, you can make a year’s worth of returns in a day. IPOs in 2014 have “popped” an average of 14% on the first day of trading. And over the past 12 months, U.S. IPOs have been up by an average of 57%, according to Renaissance.

But here's a reality check.

For all of the hype, on average, most individual U.S. IPOs lose money.

Sure, thousands of Silicon Valley types have made a fortune in IPOs by vesting their options in companies that went public -- and by selling the stock as soon as their lock up expired. But that's an insider's game.

That said, if you crunch the numbers, you'll find it still pays to invest in IPOs, even as an outsider. Looking at the IPO sector as a whole, the gains of the winners compensate for the losers. On average, the IPOs return 15.1% during the first 12 months that they are publicly traded.

Those kinds of returns won't have you driving a Porsche overnight. But they are still solid enough to beat the S&P 500 consistently -- and with less volatility than you may think.

Here are two ways you can invest in IPOs at the click of a mouse -- the first one of which I own both myself and on behalf of my clients in Global Guru Capital's “American Alpha” Investment Program.

I. First Trust US IPO Index Fund (FPX)

The First Trust US IPO Index Fund (FPX) is the granddaddy of exchange-traded funds (ETFs) that invest in IPOs. It has also outperformed the S&P 500 by almost 2 to 1 over the past five years.

More recently, FPX boasts a 37.25% return over the past 12 months and has already added 2.78% year-to-date, even as the broader market is still in the red.

FPX tracks the IPOX-100 U.S. Index, which includes the 100 largest, typically best-performing and most-liquid IPOs in the IPOX Global Composite Index during their first 1,000 trading days. The U.S. IPOX-100 Index has historically captured around 85% of the total market capitalization created through U.S. IPO activity over the past four years.

The index sticks to some strict rules. No single stock can exceed 10% of the portfolio. Companies also must have a market capitalization of $50 million or more to be included. As a result, First Trust tilts towards mid- and large-cap stocks by investing only in the largest IPOs and those that tend to offer the best risk-adjusted returns. Because the portfolio only adds names once a quarter, most holdings have been trading for a month or longer before they are purchased. That means you miss out on the big one-day pops. But you also tend to avoid the real dogs.

FPX's current top five holdings include Facebook (FB), AbbVie Inc. (ABBV), General Motors (GM), Phillips 66 (PSX) and Kinder Morgan, Inc. (KMP) which together account for 34.97% of the ETF.

II. Renaissance IPO ETF (IPO)

Launched only on October 14th, 2013, the Renaissance IPO ETF (IPO) is the new kid on the block in terms of ETFs that invest in IPOs.

This ETF tracks The Renaissance IPO Index, which is up 4.07% year to date.

The Index is a market cap weighted index and includes approximately the top 80% of newly public companies in the United States. The companies it includes must have a market cap of at least $100 million. Each constituent company is limited to a 10% weighting at the time of investment. Companies are removed from the Index two years after their initial trade date.

Larger IPOs are added at the end of their fifth trading day and the rest are added during scheduled quarterly reviews. That gives Renaissance IPO ETF (IPO) the ability to add stocks like Twitter (TWTR) to its index within five days of their debut -- much quicker than First Trust US IPO Index Fund (FPX). The more flexible strategy of Renaissance accounts for its better performance so far in 2014.

IPO's current top five holdings include the social media giant Facebook (FB), Zoetis (ZTS), Workday (WDAY), Realogy Holdings (RLGY) and Splunk Inc. (SPLK) which together account for 33.99% of the ETF.

In case you missed it, I encourage you to read my e-letter column posted last week on Eagle Daily Investor about how to double your dividends in 2014’s volatile market. I also invite you to comment in the space provided below myEagle Daily Investor commentary.