As the market prepares for the highly anticipated Twitter initial public offering (IPO), many investors will be tempted to jump in by the promise of big gains.
As we've warned you, investing in IPOs can be a very high-risk enterprise.
Winners can double or triple your money in very short order. But losers can cut your investment in half, or worse, just as quickly. Anyone who was around for the dot-com bubble of the late 1990s probably still has nightmares about the disastrous IPOs from that era.
And then there's the great difficulty that retail investors have in buying IPOs at anything close to the offer price. Anyone who tries often finds that they buy only after the IPO stock has soared, locking them out of most of the first day's gains.
But there is a way to capture the big gains in the IPO market with less risk than buying an individual newly issued stock: investing in IPO ETFs.
The fact is, despite all the headaches, IPOs often provide very hefty gains...
Just take a look at the performance this year of the Renaissance IPO index. It's up 56.6%, compared to a good but more modest 22.4% gain for the Standard & Poor's 500 index.
Its performance is tracked by the Renaissance IPO ETF (NYSE ARCA: IPO), which started trading on Oct. 16.
The First Trust U.S. IPO Index (NYSE ARCA: FPX), which launched in 2006, has also done well this year, having risen 37.48%.True, those numbers aren't as eye-popping as what you'll see from the best IPOs. Every one of the top 10 best IPOs of 2013, for example, are up at least 140% - and several are up more than 200%.
On the other hand, no one wants to be stuck with an IPO dog.
Professional Diversity Network Inc. (Nasdaq: IPDN), for example, is down 39% from its March 8 offer price. And Groupon Inc. (Nasdaq: GRPN) is down 62% from its first-day close of $26.11 back on Nov. 4, 2011.
Unless you're really good at picking IPO winners, you'll want to seriously consider investing in an IPO exchange-traded fund (ETF).
Let's take a closer look at these two IPO ETFs, because they use slightly different approaches.
Investing in IPO ETFs: Two Distinct Choices
First of all, neither IPO ETF buys in at the offer price, as most people would suspect.
The Renaissance IPO ETF is set up to buy a new stock on its fifth day of trading.
The First Trust IPO ETF waits at least seven days, although it has the option of waiting for the fund's quarterly rebalancing.
Yes, that means an IPO ETF will not benefit from a huge first-day pop. But neither will it suffer a loss if a hot IPO goes cold, like Facebook Inc. (Nasdaq: FB) did.
In fact, First Trust only added Facebook four months after the IPO.
"It worked out quite well for investors because at the time it was trading in the low $20s," Ryan Issakainen, an ETF strategist First Trust, told Reuters.
As mentioned earlier, the Renaissance IPO ETF tracks its popular IPO index, which means it keeps its annual management fee a relatively low 0.60%. First Trust's is only slightly higher at 0.65%.
Both IPO ETFs also limit how long they hold a stock, given their objective to reflect the market of new offerings.
The Renaissance IPO ETF will cut a stock loose after two years; the First Trust IPO ETF waits a bit longer, letting a stock hang on for as 1,000 days (about three years).
The Renaissance IPO ETF favors large caps, which account for 65% of its 49 stocks, whereas 33% are mid-caps and just 2% small caps. The First Trust IPO ETF, on the other hand, sets a market cap floor of $50 million and contains about 100 stocks.
Both funds weight their holdings by market capitalization. That can give the top stocks a lot of influence over the performance of the ETF, but can be trouble when you have to kick out a top performer.
For instance, the performance of the First Trust IPO ETF suffered when it had to boot Google Inc. (Nasdaq: GOOG) back in 2009.
And the very nature of the IPO market means that IPO ETFs will struggle more in down markets even as they outperform during bull markets.
Nevertheless, investing in IPO ETFs is a logical option for retail investors who crave a piece of the gains from the often-explosive IPO market.
The Renaissance IPO ETF was $20.64 in mid-afternoon trading on Wednesday. The First Trust IPO ETF was $42.72.
Money Morning Defense and Tech Specialist Michael Robinson has several steadfast rules for investing in IPOs designed to keep retail investors from getting burned.
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