Stocks are hot, but initial public offerings are not.

According to FactSet, the number of IPOs listed on U.S. stock exchanges contracted 14% last year versus 2018. The U.S. government shutdown in late 2018 that lasted until late-January 2019 contributed to some of the slowdown in listings as the Securities and Exchange Commission went offline.

Last year’s IPO market was dominated by large-cap technology stocks including Lyft, Peloton, Pinterest, Slack, and Uber. On paper it seemed like a strong group that would deliver impressive performance. Yet despite the buzz surrounding these companies, the class of 2019 failed to deliver on the sizzle.

The biggest disappointments were Lyft and Uber, which still trade well under their offering prices. Moreover, Slack Technologies—which went public via a direct listing—has underperformed.

Curiously, the underperformance of some hoped-for stars in 2019’s IPO class didn't have a negative impact on the two IPO-focused exchange-traded funds on the market. The Renaissance IPO ETF (IPO) and the First Trust US Equity Opportunities ETF (FPX) last year jumped 34.4% and 30.4%, respectively.

And they're off to a good start in 2020, with year-to-date gains of 7.1% for IPO and 3.4% for FPX versus a 1.8% rise in the S&P 500 Index.

IPO owns a basket of 57 newly launched public companies and has $43.3 million in assets. Companies that have been public for two years are eventually removed from the index, and the fund has a heavy bias toward the technology sector (at a recent weighting of 43%). The fund’s expense ratio is 0.60%.

FPX, which launched in 2006, has amassed $1.4 billion in assets. It invests in 100 stocks, making it more diversified than IPO. The fund holds the largest IPOs by market cap, and positions can remain in the underlying index for about four years. The expense ratio is 0.59%.

Does IPO investing merit the risks?
A recent study from University of Florida finance professor Jay Ritter examined the long-term results of IPOs and found that IPOs launched from 1980 to 2017 scored a 21.9% annualized gain for investors who held on during the first three years. By comparison, the one-day “pop” that IPOs experience on their first day of trading delivered an average gain of just 17.9%.

The IPO queue in 2020 will likely include Airbnb and GitLab. Both companies are expected to use a direct stock listing strategy, an approach used by Spotify and Slack Technologies during the past two years. This listing method bypasses the traditional IPO route of using Wall Street’s underwriters.

Although investing in IPOs offers investors a lottery ticket to own a piece of the future, the results can be a mixed bag. And in worst-case scenarios, single-stock blowups can sting hard.

IPO-focused ETFs offer a balance for investors who want to own the next generation of promising companies while avoiding single-stock risk. 

Ron DeLegge is founder and chief portfolio strategist at ETFguide, and is the author of “Habits Of The Investing Greats.”