Mega IPOs Threaten Index Fund Returns

Mega IPOs Threaten Index Fund Returns

Major private companies like SpaceX and OpenAI are preparing for initial public offerings (IPOs), which could significantly impact index funds. These companies are so large that if they go public, they would rank among the biggest corporations. Index funds, which aim to mirror market performance, would be compelled to purchase their stock, potentially forcing investors into these new public offerings regardless of their individual investment preferences.

The IPO Problem for Index Investors

The core issue is that IPOs have historically delivered poor returns for investors. When companies go public, it’s often because they believe their stock price is high. This means investors buying shares on the public market might be purchasing them at a premium, potentially when insiders are looking to sell. Index funds, unlike individual investors, cannot choose to avoid these potentially overvalued stocks; they must buy them if they are added to the index they track.

Fast-Track Inclusion and Market Mechanics

Index providers are considering rule changes to allow these mega IPOs into major stock indices like the S&P 500 and NASDAQ 100 much faster than usual. This is known as “fast-track entry.” Research indicates that this accelerated inclusion can cause IPO shares to temporarily outperform the market by over 5 percentage points around the inclusion date. However, this outperformance quickly reverses, with prices falling back towards their IPO levels within two weeks. This pattern suggests that intermediaries like hedge funds are buying shares ahead of index funds, knowing that index funds will be forced to buy them later, and then selling them as the price drops. This phenomenon has been described as a “shadow tax” paid by index fund investors.

The Role of Free Float

Another critical factor is “free float,” which is the percentage of a company’s shares available for public trading. Many of these upcoming IPOs, including SpaceX, plan to offer a very low free float, possibly less than 5% of their total shares. This low float can make a company’s stock more volatile. Index providers have different rules regarding float requirements, and changes are being considered. For instance, NASDAQ is altering its rules to potentially include low-float companies and adjust how they are weighted in the index, a move some see as an effort to attract these large listings.

Historical IPO Performance Lags

The evidence on IPO performance is stark. Studies show that IPOs, on average, have significantly underperformed the broader market over the long term. One study found that investors in IPOs earned about 5% per year, while similar established firms returned 12%. A more recent analysis of IPOs from 1991 to 2018 found they underperformed the market by about 2% annually. Even an ETF specifically designed to invest in IPOs, the Renaissance IPO ETF, has underperformed the total US market by over 6 percentage points annually since its inception. Low-float IPOs, which are expected for companies like SpaceX and OpenAI, have historically performed even worse, with average underperformance of around 50% from their offer price within three years.

Valuation Concerns and Index Rebalancing

High valuations at the time of IPO are a major red flag. Companies like SpaceX, with a potential valuation of $1.75 trillion and a price-to-sales ratio exceeding 100, are trading at multiples far higher than the average S&P 500 company. Generally, higher valuations lead to lower expected future returns. When these large, highly valued companies enter market indices, index providers must rebalance to reflect the market’s composition. This process can inadvertently cause index funds to “buy high” as they purchase shares at inflated prices during index rebalancing, and then potentially “sell low” if those valuations don’t hold up. This timing inefficiency can create a performance drag on index funds.

Private Markets vs. Public Markets for Investors

While some investors are eager to gain early access to private companies before they go public, this is often difficult and costly. Private markets have a high degree of survivorship bias, meaning success stories like SpaceX are rare compared to the many companies that fail. The fees and complexities associated with private investments can also erode potential gains. Even ETFs that have tried to gain exposure to private companies like SpaceX have faced challenges, with some losing money despite the underlying company’s reported growth.

What Investors Should Know

For index fund investors, the upcoming mega IPOs present a potential challenge. Index funds will likely be forced to buy shares in these companies, potentially at high initial prices, due to fast-track inclusion rules. While this is an inherent cost of indexing, these large IPOs may amplify the effect. Investors have two main options: accept this as part of the index fund experience or consider alternatives. Some investment strategies, like those offered by Dimensional Fund Advisors, aim to mitigate these issues by intentionally avoiding IPOs for a period after they list and by tilting away from the types of stocks that IPOs often resemble (small, growth-oriented, and less profitable). While direct access to pre-IPO shares is generally impractical for most individuals, understanding the risks and mechanics of IPOs within index funds is crucial for managing expectations and portfolio performance.

Source: SpaceX and OpenAI: The Mega IPO Grift (YouTube)