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April 21, 2006 4:58 pm

An index with fizz but no pop

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If you want a disciplined way to pick young comp­anies while they are still fresh, then the exchange-traded funds industry has come up with the product for you. Last week First Trust launched the Ipox 100 index fund, an ETF designed to track initial public offerings.

IPOs are best known for the dramatic “pop” investors often get on their first day of trading. This phenomenon, created in part by investment banks who are often accused of offering shares at too low a price as a favour to loyal clients, famously grew out of hand during the internet boom of the late 1990s.

The most dramatic was theglobe.com, an internet community that went public on November 13 1998. One of the more risqué early internet offerings, it featured “advice for the lovelorn” from Lola, “theglobe.com’s resident love goddess”, and a PC to telephone account advertised under the heading “phone sex just got cheaper”.

It was offered to investors at $9 a share. It closed that day at $97 a share. There are very few other ways to make a return of 977 per cent for one day’s work.

“Buy and hold” investors might not have been so happy. It now trades over the counter, has a market cap of $42.8m, and trades at 24 cents a share. Experiences such as this have given IPOs a bad reputation.

However, Josef Schuster, the financial engineer who built the Ipox index on which the ETF is designed to capitalise, offers a persuasive case. His ETF does not pick up the volatile first “pop”. IPOs are only included after they have been trading for seven days. They are dropped from the index once they have been held for 1,000 days.

Schuster is an expert on the academic work that has gone into studying IPOs’ early performance. He says they have all the characteristics of a separate asset class. This makes sense: going public gives companies opportunities they have not had before and creates new incentives. So the effects on the share price, and on the underlying performance of the company, can be expected to last into the relatively long term. After three or four years the IPO has matured into a typical public company and it becomes more relevant to compare it with other companies in its sector.

A look at the back-tested results for the Ipox appears to confirm this. Its annual returns have only minimal correlation with the Russell 2000 index of smaller comp­anies, the mainstream index with which it might be expected to have the most in common. It has beaten the Russell in six of the last 11 years and been beaten by it the other five. The two years of greatest out-performance, however, were the internet bubble years of 1998 and 1999, and the subsequent bursting of the bubble can probably be blamed for the following four years of underperformance.

Over the last 10 years – a period including both the bubble and its aftermath – the Ipox has made a compound annual return of 10.2 per cent, better than the Dow or the S&P (both 7.4 per cent), and the Russell 2000 (8.4 per cent). It has handily beaten all mainstream indices over the last two years.

Three quantitative screens guard against capturing the more overheated offerings. First, companies whose first day close is more than 50 per cent higher than their offer price are excluded.

Second, the company must float at least 15 per cent of its share capital to be included. Note that this excludes one of the most successful IPOs of last year, the Chicago Board of Trade, which operates in one of the hottest sectors of the US market.

She remains fond of the energy sector. She likes exploration companies such as Apache, Burlington and Kerr and is particularly fond of dividend payers ExxonMobil and ChevronTexaco. “Both these companies have used the excess cash they generate to pay off debts and pre-paid pension obligations. Now, they will show people what they have got.”

Finally, the company’s market cap must be above $50m. Companies that are little more than “ideas” at the time of their launch are, therefore, excluded.

Apply all these screens, and you are left with 447 names in Schuster’s Ipox Composite, of which the 100 biggest make up the – you might have guessed – Ipox 100. It is on this index that the ETF is based.

The 100 is adjusted quarterly and is weighted according to market capitalisation, with the exception that no stock can have a weighting of more than 10 per cent. Membership of the composite is quite fast moving because it must include stocks after only seven days of trading.

The Ipox will also be naturally overweight in fashion­able stocks, as sectors in vogue are more likely to see new offerings.

That is certainly the case now. The index includes the two phenomenal $400 stocks of the moment, Google and the Chicago Mercantile Exchange, which jointly account for 13 per cent of the index. It once included Goldman Sachs. Many IPOs are not start-ups but spin-offs from much larger entities, such as Genworth, formerly the insurance operation of GE, or Ameriprise, the former American Express Financial Advisors, also in the top 10 holdings.

So the ETF might be a good way to take advantage of the trend for the biggest companies in corporate America to split and look to create shareholder value.

No investment with a heavy weighting in Google and the CME can be called a value play but this ETF does look as though it could be an interesting addition to a portfolio.

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