Purchasing IPOs Prior to Index Inclusion
An opportunity for index portfolio managers
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.