The Safest Way To Profit From The Smoking-Hot IPO Market

IPOs — initial public offerings of stock — are the financial world’s Super Bowl. The enthusiasm, anticipation, and chance to make millions out of seemingly nothing are what drive investor’s excitement.#-ad_banner-#​

In this year’s third quarter, the three top-performing IPOs were Sprouts Farmers Market (Nasdaq: SFM), Benefitfocus (Nasdaq: BNFT) and Rocket Fuel (Nasdaq: FUEL), up 123%, 102% and 93%, respectively, in their first day of trading. Even if you hadn’t heard of these three offerings, big-name IPOs such as Twitter (Nasdaq: TWTR) and Facebook (Nasdaq: FB) have been on nearly everyone’s radar due to massive media coverage.

Not only do many IPOs make the company’s founders and initial investors wealthy, initial offerings usually provide much-needed cash to expand operations (and increase shareholder value). The problem for most investors is that it’s difficult if not impossible to obtain IPO shares before they’re listed. These shares go to insiders and others with special relationships with the investment house issuing the shares.

There are some “backdoor” ways in which regular investors can profit from the first day of an IPO: for example, in the case of Twitter’s IPO, investing in a high-tech incubator like Japan’s Digital Garage or a fund like GSV Firsthand Technology Value Fund (Nasdaq: SVVC) that owns Twitter’s pre-public shares. However, in the case of Twitter, these strategies fell sharply on the day of the IPO — a classic case of “buying the hype and selling the facts.” 

While this isn’t always the case, it illustrates that IPO investing can be very risky, even for insiders. All you need to do is look at Groupon (Nasdaq: GRPN) and Facebook (Nasdaq: FB) to realize that not every IPO is successful on its first day. 

According to the ETF Database, there have been 195 new company listings this year, with an average first-day gain of 17%. However, several IPOs have been massive losers: Cyanotech (Nasdaq: CYAN), for instance, plunged 64% on its first day of trading.

This underscores the volatility of IPOs in general. Some investors try to time an IPO’s first-day upward trend. While this strategy can work, it is very risky, and I don’t suggest it to anyone without strong day-trading skills. 

Not only can IPOs outperform on the date of issue, but they often continue their winning ways after their debut. For example the FTSE Renaissance U.S. IPO Index is up over 40% this year alone, roughly double the S&P 500 Index’s return of 22%. 

In my opinion, the best and safest way to capture the longer-term gains of IPOs is with an exchange-traded fund (ETF). My favorite IPO-based ETF is the First Trust IPOX-100 (NYSE: FPX), which is up 38% this year and boasts an impressive five-year average return of 24%. With more than $240 million of assets, this ETF is in the large-growth fund category. It has a 10% cap on stock weighting within the portfolio to ensure proper diversification. 

Most interestingly, the IPOX index itself is governed by rules intended to reduce volatility. For instance, the index does not hold any stock that exhibited more than a 50% gain on its first day of trading. Companies must have market caps of at least $50 million, and stocks are added to the index only after a seven-day post-IPO waiting period. Finally, the index discards any IPO after 1,000 trading days. This keeps the index in tune with the present state of the IPO market.

Risks to Consider: This has been a stellar year for IPOs, thanks to a receptive market, low interest rates and accommodative monetary policy. However, if the economic picture shifts in a bearish direction, the IPO market will be among the first to suffer the consequences. Always use stop-loss orders and diversify properly when investing.

Action to Take –> You couldn’t ask for a more picture-perfect daily chart. FPX has been trending up since January 2012, with the 50-day simple moving average acting as solid support for the advance. Every pullback to that support level has been aggressively purchased. Right now, shares have hit resistance, and price is consolidating right below the $43 level. Buying a breakout close above $43 with initial stops at $39 and a 12-month target of $53 makes investing sense.

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