Boosting an ETF with an IPO

How an Initial Public Offering Can Fortify an Exchange Traded Fund

A Market Brief
by

Steven Kim

MintKit Investing
www.mintkit.com

Disclaimer This brief is provided as a resource for information and education. The contents reflect personal views and should not be construed as recommendations to any investor in particular. Each investor has to conduct due diligence and design an agenda tailored to individual circumstances.

2012 MintKit.com

Summary
A dandy way to excel in the stock market is to beef up an exchange traded fund (ETF) with an initial public offering (IPO). By this means, the efficiency and longevity of an ETF can be bolstered by the peppy performance of an IPO. For the bulk of investors, an exchange traded fund is the best vehicle for participating in motley markets ranging from equities and bonds to currencies and commodities. In terms of scope, an ETF may cover a broad swath such as an entire industry or the global economy at large. A case in point is an index fund based on the flagship benchmark of the stock market; namely, the Standard & Poors index of 500 stalwarts on the bourse. Looking in the opposite direction, a communal pool could focus on a compact niche. Examples of this stripe run the gamut from computer hardware and real estate to foreign currencies and precious metals. Whatever the choice of market, though, an initial public offering can perk up the return on a portfolio. Since the autumn of the 20th century, a raft of studies have shown that an IPO is wont to outpace the bourse as a whole during the first year or two of its debut. On the downside, though, the basic equities of operating companies are in general inapt as the main vehicles for investment by the bulk of players. The danger lies in the vulnerability to bombshells in every industry ranging from mining and shipping to software and banking. The menace springs from a fact of life which is ignored by the simplistic models of financial economics. In the real world, companies of all stripes trip up and go bust all of a sudden, or fade out and die off in slow motion. By contrast, an index fund is much more likely to lead a long and productive life. The longevity of the vessel springs from the ceaseless process of renewal as the flagging members of the pantheon are replacing by the rising stars in the marketplace. For this

reason, the best course for the prudent investor is to funnel most or all of their savings into communal pools based on market benchmarks. On a negative note, a market index is wont to track the established firms within a particular domain. In that case, the corresponding fund will contain little or nothing in the way of newborn ventures. On the upside, though, the fresh-faced stocks tend to outpace their older peers; and likewise outrun the bourse as a whole. For this reason, a canny investor can perk up the return on investment by fleshing out a primary position in an ETF with a secondary stake in one or more fledgling stocks within the same niche. For the sake of concreteness, we examine these ideas by way of an ETF in the energy sector along with examples of IPOs in the target domain. The case study involves an index fund for a master limited partnership (MLP), a type of vehicle which is highly suited for the sober investor bent on sound returns at low risk. In this corner of the stock market, the standard bearer lies in an exchange traded fund that trades under the ticker symbol of AMLP. * * *

* * * A nifty way to earn superior returns in the stock market is to fortify an exchange traded fund with an initial public offering. In this way, the boons of efficiency and longevity offered by an ETF can be bolstered by the vigor and potential of an IPO. For the vast majority of investors, an exchange traded fund is the best vehicle for participating in sundry markets ranging from stocks and bonds to currencies and commodities. In some cases, an ETF might be broad-based. An example of the latter is an index fund grounded on a leading benchmark of the stock market as a whole. In other cases, a communal pool could focus on a narrow field. A case in point is an exchange traded fund dealing with real estate, precious metals, or medical tourism. Whatever the choice of market, though, an initial public offering can serve as an adjunct to a primary position in an index fund. As a backdrop, a host of studies over the decades have shown that an IPO is prone to outpace the stock market as a whole during the first year or two of its rollout. The vigor of the debutant also shows up in smaller niches ranging from capital equipment to consumer products. By contrast to popular wisdom, the atomic stocks of operating firms are unsuitable for the mass of investors. The equities are problematic regardless of the business, whether the underlying firm happens to traffic in mining or refining, banking or retailing. The bugbear stems from a grim fact of life which is swept under the rug by the traditional models of financial economics. To wit, the lot of all companies is to grow old and conk out sooner or later. The outturn is to clobber the shareholders who end up holding the bag of worthless stocks. By contrast, a communal pool based on a market benchmark is much more likely to endure and even flourish for decades on end. For this reason, the right move for the mass

of investors is to shunt most or all of their savings into index funds. In the latter category, the most versatile and convenient pools take the form of exchange traded funds. In line with earlier remarks, an index fund may cover a broad expanse such as an entire sector or country. Or the rig could target a narrow patch such as a particular industry or commodity. On a negative note, a benchmark of the market tends to cover the established firms within the field of interest. For this reason, the corresponding ETF is apt contain little or nothing in the way of newborn ventures. Yet, the fledgling firms tend to outsine their older rivals within the same niche as well as the stock market as a whole. For this reason, the adept investor can beef up the return on investment by fleshing out a hefty position in an ETF with a slender stake in one or more IPOs within the same field. For the sake of concreteness, we examine these ideas in the context of an ETF in the energy sector along with fitting examples of IPOs in the target market. In particular, the case study deals with an index fund for a master limited partnership, a type of vehicle which is highly suited for the genuine investor. The leading light in this corner of the bourse is an exchange traded fund that trades under the banner of AMLP.

Master Limited Partnership

A master limited partnership (MLP) is a limited partnership whose shares are traded on a stock exchange. For the prospective investor, the main attraction of the vehicle lies in the luscious flow of dividends, whose yield can reach far in excess of 5% a year. An MLP can only engage in certain types of activity allowed by government regulations. The kosher modes of business are showcased by the extraction and transport of natural resources such as crude oil or natural gas. In some cases, a limited partnership in the realm of real estate could also be structured as an MLP.

A master limited partnership pays out at least 90% of its earnings to the shareowners, otherwise known as unit holders. For this reason, the setup is a popular choice amongst investors who want to secure a lush stream of income by way of dividend payments. On the downside, though, an MLP comes with a big headache for the shareholder when the time comes for filling out their tax returns every year. The pother springs from the hassle involved in complying with an arcane set of accounting rules. For this reason, an investor who has better things to do than jump through tricky hoops for the taxman ought to avoid this type of asset within a regular portfolio. Instead, a better move by far is to consider an MLP only as a candidate for a sheltered portfolio. A plain example of the latter lies in an individual retirement account (IRA) which happens to be immune from the bane of taxes on earnings. In that case, the wily investor can bypass the busywork associated with a master limited partnership.

Benchmark and Index Fund

In 2006 a benchmark dealing with master limited partnerships was unveiled by Alerian, a purveyor of market information. The MLP Infrastructure Index covers scores of prominent names in the energy sector. The yardstick tracks the average price of the stocks, weighted by the capitalization of the shares available for trading by the general public. Four years onward, an operator of investment pools named ALPS Fund Services launched an exchange traded fund based on the Alerian index. The tracking fund trades on the U.S. bourse under the call sign of AMLP. One advantage of dealing with an ETF rather than a direct stake in the constituent stocks stems from the relative ease of dealing with the tax issues. More precisely, the dividend payments and capital gains due to the index fund can be handled in the same way as the routine for an ordinary stock listed on the bourse. On a negative note, however, the stewards of the tracking fund levied a maintenance fee of 0.85% a year of the assets under management. Such a hefty load might make a lot of
6

sense for an index fund dealing with an exotic market. An example of the latter is an obscure bourse tucked away in a remote corner of the planet. On the other hand, a master limited partnership is readily available to any investor who has access to the U.S. market. Moreover the business that underpins an MLP is apt to be more stable than the average concern listed on the bourse. Given this backdrop, an investor blessed with a sizable portfolio may prefer to bypass the index fund entirely. If the gamer is willing to monitor the Alerian index say, on a quarterly basis while updating the account accordingly, a cost-effective ploy is to invest directly in a handful of atomic stocks tracked by the market benchmark.

Initial Public Offering

From a conceptual stance, an ETF and an IPO are not mutually exclusive widgets. To bring up an example, an index fund could track a yardstick of newborn stocks during the first couple of years of their entry into the arena. In practice, though, an index fund is likely to contain few if any youthful firms listed on the stock exchange. The reason is that the benchmarks tend to focus on the stalwarts within their respective fields. By contrast, the majority of newborn stocks are lightweight as well as unproven. As a result, the greenhorns are rarely inducted into the circle of bigwigs covered by the yardsticks. In line with earlier remarks, the main draw of an ETF lies in its robustness. On the other hand, the lure of an IPO springs from its vim especially over the first couple of years. Since the autumn of the 20th century, a welter of studies have shown that fledgling stocks during the first year or two of their debut tend to outpace the bourse as a whole. An example lay in a survey of public offerings in Europe over the period from 1996 to 2010. In

the sample under review, some of the sapling firms were backed by ventures capitalists while others were not. The troupe of companies supported by venture capital included 365 names. On average, this cohort outpaced the benchmarks of the market by 8.44% during the first 250 days of trading. The latter timespan happens to be roughly equivalent to a single years worth of action in the stock market. By contrast, the larger throng of companies which had no backing from venture capitalists did not fare as well. The firms without support from the professional patrons were apt to trail behind the coached players by a modest amount. Despite the weaker showing, though, the laggers on average still managed to beat the market benchmarks by a few percent during the first year of their launch on the bourse (Bessler and Seim, 2011). In a nutshell, the good news is that both types of rookies whether backed by venture capital or not outpaced the benchmarks of the market. This study confirmed the moxie of the IPO as a front-runner in the stock market. In the next section, we compare the performance of an ETF against a clutch of IPOs in the same domain within the first year or two of their launch. The vignette deals with a portion of the bourse which happens to be more tranquil than the average niche. From a larger stance, the stocks of companies that issue lots of dividends tend to be less volatile than their stingy rivals. In this context, a master limited partnership is no exception to the rule. Thanks to the plump payouts, an MLP is apt to be more demure than the bulk of equities listed on the bourse.

Comparison of the Index Fund and IPO Sample

The performance of the communal pool and the solitary stocks is spotlighted by their relative turnout over the span of a couple of years. The chart below, courtesy of Yahoo Finance (finance.yahoo.com), covers a period of two years following the launch of the index fund in the autumn of 2010.
8

The blue line portrays the path of AMLP, the tracking fund based on the Alerian benchmark for master limited partnerships. As the exhibit shows, the communal pool bounced around by a moderate amount over the course of two years. Despite the turbulence, though, the index fund managed to garner a total return including dividends of roughly 10% over the entire stretch. Our next step is to review the performance of the newcomers during the first year or so of their entry into the arena. In view of the task at hand, each of the lonesome stocks displayed on the chart has a shorter life span than the 2-year stretch corresponding to the communal pool. As an example, a partnership named Targa Resources debuted on the bourse in late 2010. The behavior of the equity, denoted by the ticker symbol of TRGP, is portrayed as a yellow curve on the chart. By design rather than accident, the trail for TRGP starts out at the same point as the arc for AMLP. Given the choice of starting point, the divergence of paths after that juncture reflects the gap in performance for the two stocks.

From the chart, we can see that TRGP turned in rousing results. One way to interpret the outcome is to envision a change in tack within a single portfolio during the interval covered by the diagram. Suppose that a lump of cash was invested in AMLP upon its inception in the autumn of 2010. A few months later, when TRGP came on the scene, the entire stake in AMLP was liquidated. Then the proceeds from the sale were used at once to purchase the newborn stock. Next, the shares of the hatchling were held for the remainder of the investment period. Based on this gambit, the value of the account would be higher by some 90% by the end of the 2-year stretch. To keep things simple, we have of course ignored the transaction costs entailed in buying and selling the securities. An example in this vein involves the commissions to a brokerage firm or the registration fees to a stock exchange. The burden of transaction costs depends on a number of factors such as the choice of broker or the number of shares traded. Even so, a representative load for a portfolio of moderate size is a haircut in the neighborhood of 0.1 percent of the principal. The other curves on the chart can be interpreted in a similar fashion. For instance, the green line depicts the turnout for an initial investment in AMLP followed by a switchover to Mid-Con Energy Partners (ticker symbol MCEP) upon its debut. Meanwhile the red trace portrays the turnout for a similar ploy that involves Inergy Midstream (NRGM). That is, an initial stake in AMLP was converted in toto into a stake in NRGM when the newcomer stepped into the arena. The latter two schemes turned in pretty much the same results. On the upside, the overall gain surpassed the return on investment garnered by the index fund on its own. On the downside, though, the payoff turned out to be less than the bounty snagged by the combo of AMLP and Targa.

10

By way of comparison, the brown line portrays the corresponding tactic for Kinder Morgan (KMI). The latter stock fared poorly during the first half-year of its life but managed to produce a decent result by the end of the appraisal window. In contrast, the worst showing was turned in by QR Energy (QRE). The path of the stock, rendered in purple, ended up lower at the finish line compared to the starting gate. In other words, the portfolio based on a relay of AMLP and QRE shriveled up after flailing around for a couple of years. To sum up, the index fund turned in a decent showing over the course of the investment horizon. The vehicle snagged a gain of roughly 10% for its investors while displaying only a modest level of volatility along the way. By contrast, the other contenders were a lot more flighty. In spite of the turbulence, though, the majority of the newcomers managed to bag higher gains than the index fund. On the other hand, one of the saplings namely, QRE turned in a cruddy performance. The newcomer started out with a bang, but was unable to keep up with its jejune peers or even the index fund teeming with mature rivals. All in all, the case study illustrated the usual advantage of the bantam stock over the bulky fund in terms of the total return on investment. A second motif lay in the relative turbulence of individual stocks compared to the communal pool. A third feature concerned the dicey nature of an IPO, which at times can turn into a dud that ends up harming rather helping the investor.

Wrapup for Melding an ETF with an IPO

The main attractions of an exchange traded fund spring from the convenience in trading coupled with the robustness over time. Meanwhile an IPO offers the prospect of higher returns during the first year or two of its debut in the stock market.

11

Given this backdrop, an investor interested in hearty growth over the span of a year or so could earmark a small stash of funds for a handful of saplings on the bourse. In that case, the nimble player could enjoy a mix of benefits that pairs the stability of an exchange traded fund with the mojo of an initial public offering.

Further Information
A master limited partnership is a special setup that comes with a quirky set of advantages as well as drawbacks. An article at Wikipedia, whose link is given below in the References section, provides additional information on the MLP. The bugbear of faulty information on ETFs is explained in an article titled Cruddy Information on Exchange Traded Funds http://www.mintkit.com/cruddy-informationexchange-traded-funds. The tutorial also presents a palette of countermeasures for dealing with the pitfalls. The following writeup talks about the use of index funds to trump the competition in the financial ring: How to Beat the Investment Funds: Outrun Most Mutual Funds and Hedge Funds while Earning a Bonus http://www.mintkit.com/beat-investment-funds. Remarkably, a complete novice armed with a smidgen of street smarts can outshine the bulk of players ranging from casual amateurs to gung-ho professionals without breaking a sweat.

References
Bessler, W. and Seim, M. European Venture-backed IPOs: An Empirical Analysis. 2011/3/7. http://www.evca.eu/uploadedFiles/News1/News_Items/2011-0307_PR_EVCA_VC_IPO_Europe_Study_BesslerSeim.pdf tapped 2012/10/30. Wikipedia. Master Limited Partnership. http://en.wikipedia.org/wiki/Master_limited_partnership tapped 2012/10/30.

12

* * * Keywords: ETF, IPO, Exchange Traded Funds, Index, Oil, Gas, Stock, Market, Energy, MLP, Income, AMLP, Investing, Dividend, Risk, Return, Retirement, IRA

13