An IPO ETF is an exchange-traded fund (ETF) that tracks initial public stock offerings (IPOs) of various companies. Many investors are attracted to IPO ETFs because they follow a large pool of initial public offerings, rather than exposing the investor to one or a few selected companies. This process serves two main purposes:

  • To create greater ease and familiarity with IPO investing.
  • To allow for a greater degree of diversification against the traditionally volatile and unpredictable IPO market.

SEE: Exchange-Traded Funds

The Origins of IPO ETFs
The First Trust IPOX-100 (ARCA:FPX) was the first available IPO ETF, launching in early 2006. IPOX-100 follows the market in the United States for IPOs based on the IPOX-100 U.S. Index - like the soaring stock prices following Google's (Nasdaq:GOOG) IPO in 2004.

The creation of IPO ETFs is a direct result of the many successful IPOs that were offered between 2004 and 2005. The attraction to investing in a company at its IPO is that the investor can get in on the ground floor of a newer company with a high-growth potential. In the past, investors have reaped large gains from successful IPOs, like the 2006 IPO of Chipotle Mexican Grill (NYSE:CMG), in which the stock price doubled on its first day as a public company. This vehicle came together at a time when the popularity of ETFs was soaring, and many investors distinctly remembered the investment losses realized by those who took the risk of investing in one-off IPO securities in the late 1990s.

IPOX: Not All-Inclusive
However, the IPOX Index has specific stipulations that would prohibit it from including IPOs, like that of Chipotle. The IPOX Composite does not include companies with a more-than-50% gain on the first day of trading; this was put in place to avoid those securities that were thinly traded or overly volatile. Many IPOs are known for being bid up within the first weeks or months, only to drop back down to the original prices (or below) by the end of their first year on the market.

The index also excludes issuing companies for a variety of other reasons. Only U.S. corporations are accepted, and a number of investment vehicles are excluded, such as real estate investment trusts, close-ended funds, American depositary receipts from non-U.S. companies and American depositary receipts from foreign companies, as well as unit investment trusts and limited partners.

Companies that meet the requirements for the IPOX Composite also need to have a market capitalization of $50 million or more. Additionally, the IPO must provide at least 15% of the total outstanding shares. Another way that the IPOX-100 Index Fund does not allow for enormous first-day gains (like that of Chipotle) to be included within the portfolio is through only investing in securities after they have already been on the market for a period of seven days. In addition to having to be publicly traded for this period, securities are removed from the fund on their 1,000th day of trading, which means that the index could suffer when a major performer is removed.

Rules of the Fund
Google is a good example of how this 1,000-day limit can hurt the index. Google was the top performing company in the IPOX-100 index when the IPOX-100 ETF was launched, but exceeded the 1,000-day limit in 2009. The 2008 decline in the performance of the IPO index suggests that IPO ETFs are especially vulnerable to economic declines. The IPO index that the IPOX-100 ETF follows struggles to perform during difficult economic periods. Also, the vulnerability to a single major company in the index illustrates the inherent danger in IPO ETFs.

SEE: 5 Tips For Investing In IPOs

Another timing-based rule the fund has in place is that companies are added or removed from the index on a quarterly basis, which could potentially limit the IPOX-100 ETF's returns. For example, if a company peaks during the quarter before the fund adds it, an ideal investing opportunity may be lost.

IPO ETFs Under Fire
Some critics charge that investing in an IPO ETF is risky. The risk of investing in companies that are going public is often associated with the "dotcom bubble" of start-up companies. In the late 1990s, many companies were valued unusually high, which created a public buzz around IPOs. However, many of these companies collapsed shortly after the IPO, and investors lost considerable amounts of money. In recent years, underwriters seem to have adjusted to more accurate pricings for IPOs, and thus the IPO index has been more stable and predictable. Another potential problem for IPO ETFs is that the IPO companies, usually relatively small corporations, will be more prone to failing in a down market than well-established companies will.

The Bottom Line
It is yet to be seen whether this unique way of gaining exposure to IPOs will grow, but it is certainly unique. While there are some rules that make IPO ETFs risky and limited in returns(i.e., they invest and divest on a quarterly basis; they have a seven-day purchasing rule, and a 1,000-day selling rule), the funds are becoming more reliable and stable as the market becomes more comfortable with them.

Related Articles
  1. Investing Basics

    Solutions For Concentrated Positions

    Investopedia explains various tactics for divesting your overexposure to any one stock.
  2. Insurance

    Market Capitalization Defined

    Find out the differences between mega-, large-, mid- and small-cap stocks and how each suits different investing styles.
  3. Mutual Funds & ETFs

    4 Ways To Use ETFs In Your Portfolio

    To take full advantage of these vehicles, you need to know how they can fulfill certain strategies.
  4. Mutual Funds & ETFs

    Dollar-Cost Averaging With ETFs

    If you are investing small amounts regularly into an exchange-traded fund, be sure to do it right.
  5. Economics

    Protest Divestment And The End Of Apartheid

    Can selling stock really change the world? If you sell enough of it, it can.
  6. Professionals

    How to Sell Mutual Funds to Your Clients

    Learn about the various talking points you should cover when discussing mutual funds with clients and how explaining their benefits can help you close the sale.
  7. Investing

    Have Commodities Bottomed?

    Commodity prices have been heading lower for more than four years, being the worst performing asset class of 2015 with more losses in cyclical commodities.
  8. Mutual Funds & ETFs

    Top Three Transportation ETFs

    These three transportation funds attract the majority of sector volume.
  9. Professionals

    Tax Efficient Strategies for Mutual Funds

    Before you sell mutual fund shares, consider these tax strategies first.
  10. Professionals

    Fund and ETF Strategies for Volatile Markets

    Looking for short-term fixes in reaction to market volatility? Here are a few strategies — and their downsides.
  1. What are the main kinds of annuities?

    There are two broad categories of annuity: fixed and variable. These categories refer to the manner in which the investment ... Read Full Answer >>
  2. What are the risks of rolling my 401(k) into an annuity?

    Though the appeal of having guaranteed income after retirement is undeniable, there are actually a number of risks to consider ... Read Full Answer >>
  3. How do I get out of my annuity and transfer to a new one?

    If you decide your current annuity is not for you, there is nothing stopping you from transferring your investment to a new ... Read Full Answer >>
  4. How often do mutual funds pay capital gains?

    The frequency with which mutual funds pay capital gains varies. However, funds that generate a profit within a given year ... Read Full Answer >>
  5. How often do mutual funds report their holdings?

    The Securities and Exchange Commission (SEC) requires mutual funds to report complete lists of their holdings on a quarterly ... Read Full Answer >>
  6. How can I find tax-exempt mutual funds?

    Tax-exempt mutual funds can be found at many prominent investment firms. Most mutual funds offer a variety of investment ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  2. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
  3. Normal Profit

    An economic condition occurring when the difference between a firm’s total revenue and total cost is equal to zero.
  4. Operating Cost

    Expenses associated with the maintenance and administration of a business on a day-to-day basis.
  5. Cost Of Funds

    The interest rate paid by financial institutions for the funds that they deploy in their business. The cost of funds is one ...
  6. Cost Accounting

    A type of accounting process that aims to capture a company's costs of production by assessing the input costs of each step ...
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!