Proactive Indexing : Index Funds and IPOs

While there is a vast amount of research on IPOs, little research has been done from the point of view of index funds and the excess return opportunity from buying IPOs before the index inclusion date. In this paper, we analyse U.S. listed IPOs, between 2010 and 2018, which were added to the Russell 1000 and the Russell 2000 indices. We conclude that index funds could have generated excess returns by buying IPOs prior to their inclusion in indices. 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 its sector. Further we examine the risk incurred by index funds by buying IPOs early since it is not clear in advance which IPOs will eventually be included in an index. We conclude that for Russell 1000 index funds, IPOs with a larger market capitalization have a higher probability of being included in that index, but commensurately lower excess return and vice versa for IPOs with comparatively lower market capitalization. To harvest the potential excess returns, we develop a risk/return framework which could guide index portfolio managers in timing and sizing their IPO trades prior to their inclusion in indices