The Global Equity Beta Solutions research team at State Street Global Advisors continuously explores potential excess return opportunities that can generate value for our clients. For portfolios where the risk tolerance and client’s investment objectives allow such activities, State Street has many tools at its disposal, including the possibility of participating in Initial Public Offerings (IPOs) before the Index Inclusion Date when newly offered stocks are added to an index.
The research that is summarized below led to the development of a risk-return framework to guide index portfolio managers in timing and sizing IPOs trades before index inclusion. It confirms and quantifies an excess return opportunity that exists for index funds through the use of a systematic approach to participating in IPOs that are likely to be included in the various indices.
Such a strategy is only one of a range of excess return opportunities that State Street portfolio managers consider as they balance risk and return in response to client preferences. The research continues….
The JOII Article
“Proactive Indexing: Index Funds and IPOs,” recently publishing in the Journal of Index Investing, explores the excess return opportunities that may be gained by index portfolio managers and investors who buy IPOs before the index inclusion date. Authors Jenn Bender, Robert Pozen, and Mitesh Tank analyzed US-listed IPOs added to the Russell 1000 and Russell 2000 Indexes between 2010 and 2018; they found that index funds could have generated excess returns by buying IPOs before their inclusion in indices. Because index funds incur risk by buying IPOs early (e.g., it is not clear in advance which IPOs will be included in an index and which ones will have favorable performance), the authors created a risk-return framework that can help guide index portfolio managers in timing and sizing their IPO trades.
The research team and portfolio managers tracked the performance of IPOs between the IPO offer date, the close of the first day of trading after the IPO, and the close of trading on their eventual Index Inclusion Date (IID). The research sought to determine the optimal time for index funds to add IPOs in order to generate excess returns for index investors (the IID closing price was used as the benchmark). They sought to discover:
How much excess return can be generated by buying IPOs at the close on the first day of trading, or on the day of the IID announcement?
How much excess return can be generated by proactively participating in the book-building process leading up to the IPO date?
Whether the potential for these excess returns depends on the index involved, the timing of the purchase, the relative size (market capitalization) of the IPO, or the IPO’s sector.
Whether a systematic strategy could mitigate some of the risk of buying IPOs prior to the IID.
It may be possible to earn excess returns when acquiring IPO shares following any one of following three approaches: Aggressive (IPO date), Pragmatic (close of first day of trading), and Conservative (Interim date between IPO date and index inclusion).
As Figure 1 shows, the IPO date approach, which requires buying the entire position at the IPO offer price, has the highest excess returns. However, an index manager may not be able to obtain the shares required by the fund during the book-building process due to overall market demand for the offering – the manager might then attempt to buy as many shares as feasible during the book-building process and supplement this approach with either or both of the other two approaches.
While managers do not know in advance which IPOs will actually be added to the Russell 1000 and 2000 Indexes, a systematic strategy of buying securities of sufficient size can generate positive excess returns without the need to take on significant risk. At least for the Russell 1000 Index, IPOs with a sufficient market cap relative to the index have a higher probability of being included in that index. To harvest the potential excess returns, the authors developed a risk-return framework for index funds to decide how many IPOs of what size they should buy and at what time. The level of risk can be calibrated to an investor’s risk appetite so that the higher the risk appetite, the earlier the investor is willing to accumulate positions in IPOs ahead of the IID.
Figure 2 shows average excess returns from a systematic approach to buying in the book-building process for three categories of investor risk appetite (categorized by the expected weight of the security). The excess returns from all three approaches are positive, with the largest value-add possible in the most aggressive strategy. As we move from conservative to aggressive, the accuracy of correct predictions decreases, but the number of securities that qualifies for the strategy increases.
As summarized in Figure 3, initiating the position through the allocation via the book-building process has provided the highest possible excess returns for a Russell 1000 tracking index fund. The excess returns persisted until the first 20 business days after the first day of trading, albeit with lower excess returns.
Generally, the research found that index funds could have generated excess returns by buying IPOs at various times before they were included in the indices—at the IPO offer price provided they could get an allocation of the desired number of shares, at the close on the first day of trading after the IPO, or later but before the date the IPO was included in the indices. Index funds would almost always be better off trading away from the Index Inclusion Date.
ABOUT THE RESEARCH
Mitesh Tank is a Portfolio Manager and leads the core beta research within State Street Global Advisors’ Global Equity Beta Solutions Group. He led the research that underpinned the JOII article. Below Mitesh answers a few question about his findings.
What was the most surprising finding from your research, compared with what you would have hypothesized from prior studies?
Mitesh: We were expecting to see that the excess return opportunity is higher for small-cap securities (Russell 2000) than the excess return opportunity for large-cap securities (Russell 1000). This did hold true when we looked at the average excess return at index inclusion, which was 6.89% for the Russell 1000 compared to 8.59% for the Russell 2000. But the median excess returns were much more comparable, with 5.24% for the Russell 1000 compared to 4.79% for the Russell 2000. This means that the small-cap IPOs have much more dispersion in return in the first few weeks of trading compared to comparatively larger IPOs that get included in Russell 1000. Perhaps this is not overly surprising given that small cap stocks tend to have higher volatility.
The findings seem to point toward consideration of an “aggressive” approach, one which builds the full position during the book-building phase of the IPO (when that is possible). Are there reasons why a conservative or pragmatic approach might be chosen for a specific IPO?
Mitesh: Any investment approach is a function of the client investment objectives and risk constraints. For clients keen to generate excess return over and above the index return, an “aggressive” approach might be appropriate. As with any investment approach, there could be periods of underperformance. Clients who focus more on tight tracking error, and tracking the benchmark index as closely as possible, may feel that a conservative or pragmatic approaches is appropriate.
Are there any particular advantages that State Street has in executing this type of strategy?
Mitesh: State Street Global Advisors has incorporated this approach in our core indexing offering to clients. The client can choose to participate in this excess return opportunity. Most of our portfolio managers have more than a decade of experience managing indexed mandates, and given the global nature of our trading capabilities, we are able to take advantage of not only the IPO excess return opportunity but also many such proactive return enhancement techniques. Also, given our presence as the third largest asset manager in the world and as a long-term buy and hold manager within our index mandates, we are often given the opportunity to access these offerings with a favorable allocation.
How might this type of proactive inclusion of IPOs logically be extended further?
Mitesh: At State Street Global Advisors, the research team always focuses on exploring excess return opportunities that would be of interest to our clients. The current research paper focuses on Russell indices, as the US has dominated the IPO market. But we are currently exploring the best approach to tackle fast-track entry of IPOs in other index series. It will be a different approach because the index inclusion date would be only a few days after the first day of trading, unlike the current study in which the index inclusion date can be as long as approximately 50 trading days later. Each index family has its own treatment around inclusion of companies following their IPO.
When might it not make sense to buy IPOs before index inclusion?
Mitesh: As discussed in the article, irrespective of the approach – aggressive, conservative, or pragmatic – there is always a risk that the IPO security does not get added to the index. One of the reasons for that to happen could be a fall in the security’s price once it starts trading. Hence, in times of volatility, such as in March-April 2020, it would make sense to avoid buying IPOs before index inclusion. There is also the risk that the performance of any given IPO does not end up being favorable.
Given the wide dispersion of excess returns you found among sectors, and among companies of varying sizes, how might this data inform the decisions of investment managers seeking to track indexes?
Mitesh: Generally IPOs hail from sectors which have had a few good years behind them. It was no surprise that the Technology sector was the one with the most IPOs included in the Russell 1000 over the analysis period from January 2010 to December 2018. Such sectors also provided the best first-day performance, given the tailwinds of market exuberance that they benefited from. Rather than expecting the same sectors that were highlighted in the article to outperform, investment managers may want to reflect on the recent performance of IPOs from similar sectors before participating in IPO book builds.
The IPOs that you tested all took place during a 10-year Bull market. Do you think that your findings are extendable to Bear markets as well?
Mitesh: Statistically, Bear markets are shorter than Bull markets, and I would also expect the number of IPOs to dry down in bear markets as most companies would want to launch an offering in a better market environment. History does not repeat, but it definitely rhymes. This has been our first attempt to view IPOs from the lens of index funds. I am sure that the risk-return framework developed in the paper would guide index portfolio managers in timing and sizing their IPOs trades before index inclusion over a reasonable time period. As mentioned earlier, index funds may want to avoid participating in IPOs in highly volatile periods, which may be signaling the start of a Bear market.
Any final thoughts?
Mitesh: I would like to emphasize that an excess return opportunity exists for index funds by participating in IPOs through a systematic approach. This is one of the first, if not the first, papers to look at IPOs from the lens of index funds, so I am sure it will raise more research and implementation questions. We are currently working on some of those questions, but it’s too early to talk about those findings.
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