The New Wave of IPOs: Initial public offerings are back in vogue. Here’s why investors should be wary

July 12, 2013, 5:57 p.m. ET

The New Wave of IPOs: Initial public offerings are back in vogue. Here’s why investors should be wary.

TELIS DEMOS and JOE LIGHT

There are lots of IPOs to pick from. But that doesn’t mean you should. The U.S. initial-public-offering market is on track this year to produce the most deals since 2007. In the second quarter, 80 companies publicly began the process of registering for an IPO in the U.S., more than double the number that did so in the same period a year ago, according to accounting firm PricewaterhouseCoopers. The publicly available IPO pipeline includes 140 companies seeking to raise a total of $30.5 billion, the firm said. That is on the top of the 95 companies that already have debuted this year, which have raised $23 billion, according to market-data firm Dealogic. Some of the best-performing IPOs this year have been those of familiar companies, such as SeaWorld Entertainment, SEAS -1.54% whose shares are up 42% since its April debut; restaurant chain Noodles & Co.,NDLS -1.72% which has jumped 139% from its June IPO; and Norwegian Cruise Line Holdings, NCLH +0.32% up 66% from its January deal. By comparison, the Standard & Poor’s 500-stock index is up 18% so far this year. There have been duds, too. Gogo, GOGO +6.88% which provides Internet services on airplanes, and online ad network Tremor Video TRMR -0.38% are down 18% and 20%, respectively, since their June debuts.All this shows how easy it is to be dazzled by IPOs—and be burned by them. Some deliver eye-popping short-term returns, and can, over time, expand from small companies into very big ones, as Microsoft MSFT -0.04% or Apple AAPL -0.18% did back in the 1980s. Between 1980 and 2011 the average “pop” of an IPO from its offering price to where it closed on its first day of trading was 18%, according to Jay Ritter, a finance professor at the University of Florida who has studied the IPO market for 30 years.

There are more big names in the pipeline this year: department store Neiman Marcus, coupon website RetailMeNot and retailer Claire’s.

Many of these IPOs are likely to garner attention from small investors, including those who were excited about—and then disappointed by—Facebook‘s FB +0.39%botched 2012 debut and who may be looking for the right moment to get back into the game.

But as Facebook’s IPO reminded investors who might have forgotten the lessons of the dot-com boom, early expectations can lead to disappointments. For one thing, the market is still nothing like the tech bubble of the late 1990s. For example, in 1999, 112 U.S. company IPOs doubled in price on their first day of trading, according to Mr. Ritter, excluding stocks with initial prices below $5 a share. Since 2011, only three—social network LinkedIn,LNKD +1.72% software developer Splunk SPLK +2.46% and Noodles & Co.—have doubled on the first day.

Indeed, IPOs tend to underperform the market over longer periods, according to Mr. Ritter. The average return for an investor who bought after the first day and held for three years was 21% versus 41% for the broad U.S. stock market, his research has found.

The lesson, experts say, is that the IPO market, whether hot or cold, is treacherous for the average investor. While institutions such as mutual funds can take advantage of the first-day pop to boost their returns, it is very difficult for all but the most dedicated individual investor to do so.

If you do want to gamble on IPOs, there are ways to improve your chances. Here is what you need to know.

Getting Access

Most investors will have trouble buying directly into an IPO. Typically, less than a third of an IPO’s shares are set aside for what investment bankers call the “retail” market, which includes very wealthy clients as well as small investors, with the rest going to institutional investors such as hedge funds and mutual funds.

Most of the retail shares go to clients of brokerages that are affiliated with an IPO’s underwriters—the investment banks responsible for selling shares to the public. Few, if any, clients ever get all the shares they ask for, because demand almost always exceeds supply, especially for bigger-name deals.

Facebook, for example, was oversubscribed, despite being the biggest U.S. tech IPO ever at $16 billion.

Full-service brokerages, such as Bank of America BAC +2.00% Merrill Lynch,Morgan Stanley, MS +2.27% UBS UBS -0.40% and Wells Fargo, WFC +1.77%have internal guides for how to distribute the shares.

There are some general rules of thumb, though. For one, your investment adviser must be someone who frequently asks for IPO allocations from his firm, and you must have demonstrated a consistent interest in IPOs, not just the hottest deals.

UBS, for example, tends to allocate 10% to 30% of an IPO to retail investors, with the bulk of the shares going to a concentrated group of financial advisers who frequently participate in new offerings, says Charles Buckley, head of the firm’s Americas global family office, which caters to high-net-worth investors.

UBS’s financial advisers then decide how to split IPO shares among their clients and might give preference to those who generate more business or have expressed consistent interest in certain kinds of IPOs, Mr. Buckley says.

In addition, some deals are done with retail demand in mind. Investment bankers say that a higher percentage of yield-oriented IPOs, such as real-estate investment trusts, master limited partnerships or closed-end funds, tend to go to retail investors.

Some investment banks also give a small portion of some IPOs to online brokerages, such as TD Ameritrade AMTD +1.65% and Fidelity Investments, which are two of the largest. But the brokerages warn that most investors will receive many fewer shares than they asked for. Some IPOs also require minimum account sizes of as much as $500,000.

Finally, investors who do get shares in an IPO should hold on to them for a while. Those with a reputation for getting in on an IPO and “flipping it,” or selling the stock within weeks or a month of the IPO, might not be given future allocations.

At Fidelity, if a customer flips an IPO within 15 days, the investor can’t invest in another one for six months, and longer after multiple flips, according to the company. TD Ameritrade customers might have IPO access restricted if they repeatedly flip within 30 days, the company says.

The Aftermarket

Due to the difficulty of participating in IPOs directly, most interested investors will have to pick up shares after the stock starts trading. That means they will miss the initial pop—and on average, the long-term returns for stocks bought just after an IPO aren’t as impressive.

This year, for example, the pop has been a big part of IPO price gains. Stocks of companies that have gone public in the U.S. this year are up on average 29%, according to Dealogic, from their debut through Wednesday’s close. Those IPOs have risen 13% from where they closed at the end of their first day of trading.

IPOs also come with some unique risks in the short term. Right after an IPO, for example, only a portion of the company’s shares are freely traded—sometimes less than 20% for many tech stocks.

The thin liquidity makes the stocks harder to trade, says Steve Quirk, who oversees strategy for the trader group at TD Ameritrade. He says that many investors wait several months—or at least one operating quarter—for the stocks to “season” before betting on a company’s long-term future.

“Why not let a couple other people buy it and see how it works out?” he says. “You don’t want to be the person that discovers it isn’t everything you thought it was.”

The stocks also can suffer price drops when more shares are released to the market. A study by brokerage firm Charles Schwab SCHW +1.02% last year showed that more than 50% of IPOs from May 2009 to May 2012 fell from their first-day closing price during the first three and six months of trading.

Even stocks that have risen sharply over the longer term were turbulent during those periods. For example, LinkedIn has more than quadrupled to $199.96 since its May 2011 IPO, when it was priced at $45, and doubled from its first-day closing price of $94.25. But its shares traded below $65 in November 2011, the first time LinkedIn’s pre-IPO investors could sell more shares. Investors who bought after the first day would have faced losses at that price.

It is important for investors to try to analyze IPOs on a case-by-case basis, in the same way they would approach any stock pick, says Jim Krapfel, an equity analyst at investment research firm Morningstar MORN -0.62% who specializes in IPOs.

IPOs don’t offer as many avenues for research as other stocks, such as analyst reports. Investment banks don’t publish research on IPOs until at least 25 days after they begin trading, to avoid been seen as helping to pump up the IPO.

However, every IPO does have a detailed prospectus on file with the Securities and Exchange Commission, which includes historical performance figures and an extensive discussion of the company’s risks. Investors can watch presentations by company management on the website RetailRoadshow.com.

The best-performing IPOs tend to have more than $60 million in annual revenue, Mr. Ritter says. Historically, those companies at least haven’t done worse than the rest of the market, he says.

Ultimately, Morningstar’s Mr. Krapfel says, investors shouldn’t invest more than 10% of the stock portion of their portfolios in IPOs and should think of them as a substitute for the riskiest parts of their stock holdings, such as small-company stocks.

Other Options

There is an easier—and safer—way to get IPO exposure: Entrust the task of picking the best ones to an active manager with expertise in picking new companies as part of a broader portfolio. An institutional manager has a much greater chance of getting into an IPO at the ground floor, and getting a large allocation of stock.

Similarly, passively managed index funds tend to pick up shares after new companies are added to major stock indexes, such as the S&P 500, though it can be months, even years, before some indexes pick up IPOs.

For more concentrated exposure, there is a mutual fund and an exchange-traded fund that invest exclusively in IPOs.

The First Trust US IPO Index FPX +0.61% ETF passively tracks an index that includes the 100 largest U.S.-based company IPOs and spinoffs for their first 1,000 trading days, or roughly four years, and is rebalanced quarterly. The fund has an annual expense ratio of 0.6%—or $60 out of every $10,000 invested—and has had an average annual return of 26% over the past three years through Thursday, according to Morningstar, versus 18% for the S&P 500.

Renaissance Capital, an IPO research and investment firm based in Greenwich, Conn., manages the Global IPO Plus Aftermarket Fund, which has about $10 million in assets under management.

The fund does participate in some IPOs, but usually buys them once they begin trading. It has an expense ratio of 2.5% and has had an average annual return of 9.7% over the past three years. The minimum investment is $5,000, or $2,500 for individual retirement accounts.

The stocks in the Renaissance fund are “unseasoned, not as well known, and not widely held. So you get exposure to something that [many mutual] funds won’t have exposure to,” says Kathleen Smith, who co-founded Renaissance in 1991. The fund’s largest holdings as of the most recent report date, March 31, are LinkedIn and Facebook, which together make up about 10% of its assets.