Proactive Indexing: Index Funds and IPOs

Robert Pozen’s path-breaking article, co-authored with two portfolio managers at State Street Bank, examines Index Funds. Index funds now buy stocks shortly before or at the time they are added to the index — which is usually 3 to 6 months after they are initially offered to public investors. With the increasing size of index funds, this practice has far reaching implications for the volume and pricing of IPOs ( initial public offerings ).  

The article shows that index funds could generate excess returns if they bought IPO stocks when they were initially offered to public investors — during the book building process or on the first day of trading.

These returns were significant in an analysis of all US IPOs that were added to the Russell 1000 index of large stocks and the Russell 2000 index of smaller stocks between 2010 and 2018.  

Of course, there is risk involved in buying these IPO stocks early since they might not be included in the relevant index.  The article concludes that IPOs with a larger market capitalization have a higher probability of being included in the relevant index, but a lower excess return than smaller cap stocks.  The article therefore develops a risk-return framework that can guide index funds in timing their purchases of IPO stocks before they are actually included in the index.

Read the full article here.