- Indexes are often used as the equity universe for asset managers to create and/or benchmark portfolios. The inclusion of stocks in those indexes soon after their IPOs provides a broader opportunity set.
- We found that IPO stocks performed in line with the underlying MSCI World Index for most years over the past two decades.
- There were two notable exceptions: the tech-bubble burst (2000-2002) where IPO stocks underperformed the index and the post-COVID-crisis rally of technology stocks in 2020 when IPO stocks outperformed the broader market.
Following their initial public offering (IPO), companies often become eligible for inclusion in public-equity indexes, which asset managers use to create and/or benchmark portfolios. Depending on the size, liquidity and other factors, these stocks may be added to indexes soon after their IPO, or following a grace period and after meeting additional criteria.1 There is a body of research dedicated to different aspects of IPOs, from pricing to distribution to the behavior of stock prices after IPOs. Some of this literature has shown evidence of underperformance of IPO stocks three to five years after their listing.2 In this blog post we investigate the impact of IPO stocks on the performance of indexes, which in turn affects investors as they select an underlying index.
IPO Stocks in the MSCI World Index Over Time
In our analysis we focus on developed markets from May 1999 to December 2020, using the MSCI World Index as a proxy.3 Given that the objective is to assess the impact of IPO stocks on the risk and return of MSCI World and its underlying indexes, we only consider IPO stocks that made their way into the index soon after the IPO.
The first step is to identify these stocks, which we define as those that entered the index within five years after their listing date, excluding spun-off companies. The exhibit below shows the IPO stocks included in the MSCI World Index, broken down by the Global Industry Classification Standard (GICS®)4 sector and IPO year. While the total number of IPOs added to the index and its sector composition varied over time, the information-technology, financials and consumer-discretionary sectors had the highest numbers of IPO stocks, and we observed a peak during the tech bubble and another rise prior to the 2008 global financial crisis. In terms of geography, we saw a high number of IPOs in the U.S., but also a good contribution from a wide range of other developed markets.
Sector Breakdown of IPO Stocks Added to the MSCI World Index by IPO year
Geographic Breakdown of IPO Stocks Added to the MSCI World Index by IPO Year
IPO-Stock Performance After Index Inclusion
To see how included IPO stocks performed after inclusion, we calculate their annualized returns for the period that begins with their inclusion and ends five years after their IPO.5 Looking at the full period of analysis, on the left-hand side of the exhibit below, we see the distribution is more tilted toward negative returns, though there are more extreme cases (>80% or <-80%) on the positive vs. the negative side.
Over the more recent period, the last five years, we can see on the right-hand side of the exhibit that there is a significant tilt toward the right, highlighting attractive performance of recent IPO additions. This performance was primarily driven by information-technology-sector stocks and from specific IPOs such as Afterpay Ltd. and The Trade Desk Inc. The exhibit also highlights several recent IPOs with extreme positive performance.
Distribution of IPO Stocks’ Returns Five Years After Inclusion
Impact of IPOs on Index Performance
The return distributions above are indiscriminate of the market cap of any IPO stock or its weight and impact on the index. To explicitly measure the impact on index performance we simulate two indexes:
- World ex-IPO: A custom MSCI World Index where IPO stocks are added five years after IPO
- IPO: An index of IPO stocks. IPO stocks that are added to the MSCI World Index are added to this index and removed five years after their IPO date.
The World ex-IPO Index shows how the MSCI World Index would have performed if IPO stocks were not considered for inclusion until five years after the IPO. The IPO index gives us an indication of how IPO stocks that make their way into the MSCI World Index perform after inclusion. Loosely speaking, the combination of the two simulated indexes equals the actual MSCI World Index.6
As we see in the exhibit below, the performance of both hypothetical indexes was mostly affected by the 2000 tech bubble and its aftermath, and the post-COVID-crisis period, to a lesser extent.
Hypothetical World ex-IPO Index Performance Relative to MSCI World
Hypothetical IPO Index’s Performance Relative to MSCI World
There Were Benefits to Including IPOs in Indexes Sooner
We showed that IPO stocks performed in line with the underlying MSCI World Index for most years over the past two decades with two notable exceptions: the tech-bubble burst (2000-2002) where these stocks underperformed the MSCI World Index and the post-COVID-crisis rally of technology stocks in 2020 when IPO stocks outperformed the broader market.
Many indexes are often used as the starting universe for portfolio managers and therefore are designed to represent the full equity opportunity set. The timely inclusion of IPO stocks into relevant indexes is important to achieve this objective. Additionally, many IPO stocks represent important emerging themes and/or disruptive technologies, and we believe their inclusion into indexes is important.
1For an IPO stock to be eligible for inclusion in an MSCI index, the new issue must have started trading at least three months before the implementation of MSCI's Semi-Annual Index Review. Large IPOs may be sooner, subject to a minimum market cap and float-adjusted market cap. For more details, see: “MSCI Global Investable Market Indexes Methodology.”
2It should be noted that some research demonstrated this underperformance disappeared when risk factors were controlled for. For instance, see Ritter, Jay R. 2011. “Equilibrium in the Initial Public Offering Market.” Annual Review of Financial Economics 3: 347-374
3The MSCI World Index includes large- and mid-cap stocks in developed markets. Smaller stocks and emerging markets are not part of the analysis.
4GICS is the global industry classification standard jointly developed by MSCI and S&P Global Market Intelligence.
5For stocks that were excluded from the index before five years, the shorter period is used. For periods less than one year, the returns are not annualized. Returns are net of the relevant country index’s returns in USD.
6The hypothetical World ex-IPO and IPO Indexes are rebalanced monthly to ensure timely treatment of IPOs. The standard MSCI World Index is rebalanced quarterly.