NEW YORK (TheStreet ) -- Many investors dream of making a killing with an initial public offering. But the track record of IPOs is discouraging.During the 1990s bull market, a crowd of fledging Internet companies soared and then crashed. Last year, Facebook's ( FB) troubled launch served as a reminder that even strong companies can flop on their first day. In a recent study, T. Rowe Price tracked 4,500 companies that went public between 1995 and 2007. Of those that had less than $100 million in revenue on the first day of trading, only one out of 20 grew to $1 billion in revenue. That history would seem to stack the odds against First Trust US IPO Index ETF ( FPX). But the ETF has been delivering impressive results. During the past five years, First Trust returned 9.8% annually, compared to 6.1% for the S&P 500, according to Morningstar. The fund appears to be succeeding because its index methodology systematically avoids some shaky start-ups and emphasizes IPOs with more staying power. For starters, the index eliminates small companies, which can be prone to bankruptcy. In addition, the portfolio does not include any stocks that recorded dramatic rises or falls on the first day of trading. Stocks that stumble as they leave the starting block are prone to continue disappointing, says Ryan Issakainen, ETF strategist for First Trust Advisors. High flyers can also be dangerous. "If a stock shoots up 100% on the first day, then it could be too expensive," he says.
Of the companies that survive the initial screens, the index includes the 100 largest. The portfolio is rebalanced every quarter. Companies that drop below the top 100 rankings are eliminated and new stocks join. Holdings can stay in the index for up to 1,000 trading days, or about four years. Because it emphasizes the biggest companies, the portfolio includes many familiar names with long track records. Among the top 10 holdings are General Motors ( GM), Kraft Foods ( KRFT) and Hyatt Hotels ( H). Besides IPOs, the index can also include spinoffs. Those occur when a company sells or distributes a subsidiary. Stocks of spinoffs often perform well because newly independent managements cut costs and focus on core businesses.
Seeing the big returns, you may be tempted to try your hand at picking IPOs. But keep in mind that the First Trust strategy differs from the approaches that investors often take. The fund never buys anything during an IPO's first week, a period when trading can be erratic. Because the portfolio only adds names once a quarter, most holdings have been trading for a month or longer before they are purchased. By that time the initial turbulence typically calms. In contrast, many investors aim to buy IPOs at the offering or on the first day of trading. While many investors prefer small IPOs, First Trust favors giant issues. "The largest IPOs tend to give you the best risk-adjusted returns," says Issakainen. Follow @StanLuxenberg This article was written by an independent contributor, separate from TheStreet's regular news coverage.