The Answer to Your IPO Dreams?

Everyone wants to get a head start on buying into tomorrow's hottest stocks. But before you assume that you're really going to get the inside track on a hot IPO, you need to check the details. You might be disappointed to discover that you don't get any better treatment than anyone else who bought shares on the open market.

Within the universe of exchange-traded funds, one ETF seems to hold the key to the IPO market. Look at the holdings of the First Trust US IPO Index ETF (NYSE: FPX), and you'll find familiar names of companies that have just recently gone public, often with great fanfare and big profits. Is the First Trust ETF the key to gaining access to exclusive IPOs?

The benefits of IPOs
Initial public offerings get huge amounts of attention, and for a very good reason: They're designed to attract investor interest. Companies put on road shows encouraging financial professionals and potential investors to create a buzz about their IPO shares, in the hopes that demand will provide a burgeoning market in the stock once it trades publicly.

Of course, a successful IPO means different things for different people. For the company going public and the underwriters working on the IPO, making sure the new stock has enough buyers at an acceptable price is crucial. But for investors who are fortunate enough to be able to buy shares directly from the company, success is often measured by how big a pop the shares have once they start trading on the secondary market.

Two examples show how this tug-of-war typically plays out. For SodaStream International (Nasdaq: SODA), shares went public at $20 per share, the upper end of the range the company expected to get. On its first day, the stock jumped 20%. And in just three weeks, shares fetched nearly double what lucky IPO investors had paid.

In contrast, General Motors (NYSE: GM) raised its planned IPO price prior to going public, with shares eventually going for $33 rather than its original range of $26 to $29. That meant that pre-IPO GM investors, including the U.S. government, got 14% to 27% more for their shares than originally expected. But when shares closed the first trading day at $34.19, the pop of less than 4% paled in comparison to many more exciting public offerings.

Bowing out entirely
As you can see, first-day IPO trading can be a crapshoot. But as it turns out, the First Trust ETF neither gets inside access to IPO shares nor tries to grab shares in the chaos of the first few trading days. Instead, the index it tracks waits until the end of the sixth trading day before adding a new company. In other words, the ETF doesn't have any advantage over what you could do yourself.

Nevertheless, the fund offers an interesting mix of huge successes and big failures. For instance, Molycorp (NYSE: MCP) debuted last July amid huge investor interest in rare earth metals, on which China has imposed tight export restrictions. The shares rose as much as 400% by early January before falling back in the past month. Ancestry.com (Nasdaq: ACOM) is an earlier example of this phenomenon; its shares nearly tripled from its November 2009 IPO.

On the other side of the coin, Smart Technologies (Nasdaq: SMT) went public at $17.50 and hasn't traded that high since. After struggling out of the starting gate, the company issued disturbing guidance last November that sent the stock for a loop. Discover Financial (NYSE: DFS) is another example of a stock that's well down from its IPO price, although it has recovered from much greater losses stemming from the financial crisis.

A good fund?
On the whole, the First Trust ETF has put up good performance lately, with average gains of 37% annually in the past two years. Longer term, though, the fund's performance has been a lot less impressive. Those gains fall to just 1.4% per year since early 2007 -- enough to outperform the S&P 500, but certainly not jaw-droppingly impressive.

Given that the ETF is market-cap weighted, its big positions overwhelm some smaller picks. GM, for instance, makes up more than 10% of the fund, while Molycorp is less than 1%. Because of that, you may prefer to take your own positions rather than counting on the IPO index to make picks for you.

IPOs are an interesting investment opportunity. But without true inside access, those first-day pops that IPOs are famous for are just as likely to hurt you as help you.

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