Why Index Funds Steer Clear of the IPO Market -- WSJ

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Some experts think that may start to change

This article is being republished as part of our daily reproduction of WSJ.com articles that also appeared in the U.S. print edition of The Wall Street Journal (September 5, 2017).

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Index funds have made their presence felt in a big way in every corner of the stock market except one: initial public offerings.

What would it take to change that?

Only a limited number of index funds and exchange-traded funds have moved to quickly include certain shares just after their IPOs -- largely depending on the size and availability of the offering and the size of the company.

IPOs, meanwhile, by their nature, involve companies that have no trading histories and that tend to offer investors much less information compared with more-established publicly traded companies.

Index firm MSCI Inc., for example, generally requires at least three or four months of trading before a new stock can be considered for an existing or new index. There are exceptions. Large stocks, based on relative market cap within a specific segment, for example, can be included in an MSCI index as soon as 10 days after an IPO, with an announcement about the pending inclusion made on Day 1 of the stock's initial offering if the company is expected to meet market-cap and trading requirements.

CRSP U.S. Equity Indexes, used by many Vanguard index funds and ETFs, publishes similar criteria for both standard inclusion and for "Fast Track" inclusion of IPO shares, as do S&P Dow Jones Indices and FTSE Russell, among others. Index methodologies usually include an annual or semiannual "reconstitution," wherein eligible stocks are swapped in (or out) based on published criteria. IPOs, including splits and spinoffs, can be special cases for quicker inclusion.

The existence of such index rules, however, hasn't barred all index-fund managers from the new-issue market. For example, some index funds can participate in IPOs or buy a stock before it enters the index, should the manager deem it necessary for tracking. Again, that would really only be the case for large, liquid IPOs, including spinoffs.

Snap's 'no' vote

Recently, a possible sticking point for more inclusion of IPOs in index funds emerged. In the IPO of Snapchat parent Snap Inc., the shares had no voting rights. While a handful of public companies have dual-class shares that award supervoting to insiders -- such as Alphabet, Facebook and several family-controlled media companies -- Snap's IPO was the first to offer no voting shares to the public.

After consultation with clients, index firms S&P Dow Jones Indices and FTSE Russell said this summer that they would limit inclusion of companies with dual-class shares in their indexes. MSCI's consultation closed on August 31. In January, a coalition of major investors, including index-fund giants BlackRock and State Street Global Advisors, called for a ban on dual-class stock.

So far, major players directly involved in the IPO market, including startups, investment professionals and regulators, aren't pushing for IPO shares to be included in index funds from Day 1, in part because there is less IPO activity in general these days.

In addition, startups have many other attractive options for attracting investment these days. Some argue that for company founders and early investors, the benefits of being a public company have receded in comparison with the massive increase of the private capital markets, including venture capital, private equity, sovereign wealth and family offices.

Change coming?

Some market professionals believe the limited presence of IPOs in ETFs could change. For instance, more index funds could decide to buy IPOs sooner than their current rules allow, or index providers could systematize a process for both broad-based and sector index funds to participate at the onset of a new issue.

ETFs designed to invest in IPOs have had a mixed record. These rules-based funds aren't as strict on index inclusion for new issues as the institutional index firms -- MSCI, FTSE Russell, S&P Dow Jones and CRSP -- which are mindful of the trillions of dollars of investor money that tracks their indexes or uses them as benchmarks. Including an IPO on the first day of a listing, or very soon after, could push a torrent of money to a stock that doesn't have the liquidity or capacity to support it.

The $14.4 million Renaissance IPO ETF (IPO), which can hold IPO shares as soon as five trading days after listing and until their 500th trading day, has experienced $19.2 million in outflows since its late 2013 launch. The performance demonstrates the challenge of investing in IPOs. It has underperformed the Mid-Cap Growth category on a three-year annualized basis (a return of 4.7% compared with 6.9%), but is up 26.8% this year compared with 13.7% for the category, says Morningstar. It has a 0.60% expense ratio.

The $860 million First Trust US Equity Opportunities ETF (FPX) tracks the IPOX 100 index of the largest new offerings over their first 1,000 trading days. According to Morningstar, the 11-year-old fund has outperformed Large-Cap Growth over the past 10 years annualized, 11.1% compared with 7.9%, but has underperformed in 2017, 14.1% compared with 18.2%.

Both managers also offer IPO ETFs for non-U.S. securities. First Trust International IPO ETF (FPXI) has just $20.6 million in assets and Renaissance International IPO ETF (IPOS) has $2.3 million.

Mr. Weinberg is a writer in Connecticut. He can be reached at reports@wsj.com.

(END) Dow Jones Newswires

September 05, 2017 02:47 ET (06:47 GMT)