Proactive Indexing: Index Funds and IPOs

Although a vast amount of research on IPOs exists, little research has been done from the point of view of index funds and the excess return opportunity gained from buying IPOs before the index inclusion date. In this article, the authors analyze US listed IPOs added to the Russell 1000 and Russell 2000 Indexes between 2010 and 2018. They conclude that index funds could have generated excess returns by buying IPOs before their inclusion in indexes. However, the potential for excess returns differs depending on the index involved, the timing of the purchase, the relative size (market capitalization) of the IPO, and the IPO’s sector. Further, the authors examine the risk that index funds incur by buying IPOs early, as it is not clear in advance which IPOs will eventually be included in an index. The authors conclude that for Russell 1000 Index funds, IPOs with a larger market capitalization have a higher probability of being included in that index but have a commensurately lower excess return. The reverse is true for IPOs with a comparatively lower market capitalization. For the potential excess returns to be harvested, the authors developed a risk–return framework that could guide index portfolio managers in timing and sizing their IPO trades before the IPOs are included in indexes. TOPICS: Fundamental equity analysis, passive strategies Key Findings • Index funds tracking the Russell 1000 and Russell 2000 could have generated excess return by buying IPOs before their inclusion in indexes. • The potential for excess returns differs depending on the index involved, the timing of the purchase, the relative size (market capitalization) of the IPO, and the IPO’s sector. • The authors develop a risk–return framework that could guide index portfolio managers in timing and sizing their IPO trades before their inclusion in indexes.