As you might imagine, we’ve gotten a lot of questions over the last couple of weeks about the SpaceX IPO and how it may impact investors’ portfolios. To help clarify some concepts around IPOs, and SpaceX in particular, we sat down with Althea Trevor, Senior Investment Director at Dimensional Fund Advisors.
Read or watch the discussion to find out more about how IPOs work, why hype doesn’t always equal returns, and what the SpaceX IPO reveals about risk, index investing, and smarter portfolio decisions.
Key Takeaways From Our Conversation On the SpaceX IPO With Dimensional’s Senior Investment Director Althea Trevor:
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Interview with Althea Trevor of Dimensional Fund Advisors, re SpaceX IPO
Jim: What is an IPO?
Althea: IPO stands for initial public offering. Basically what it means is it’s the first stock offering on a public basis that a company’s making. Prior to this, a company might have gotten investment from private investors, not something that’s publicly listed on a stock exchange. This is the first time a company is actually selling shares to the public.
It’s one of the ways that new companies can open themselves up to public investment. It’s probably the one that we’ve all heard of quite a lot. There are other ways companies can open themselves up, other ways called “special purpose acquisition” vehicles and other types of acronyms, but IPO is one of these big ways, and oftentimes there are a lot of headlines associated with this.
We’ve all read about SpaceX in the news. It’s common that, with a lot of these IPOs, there tends to be a lot of excitement and headlines going on in the build-up to it. So it’s natural that a lot of folks might have questions about what this actually means.
Jim: And the excitement around it tends to create a little bit of FOMO; people want to get access to these things. There seems to be this feeling that if you can get in on an IPO, that it’s going to explode and do really well and you’re going to be really, really rich from doing that. I’m going to get your perspective on that in a little bit. But just to summarize, that’s when it goes out to the public and essentially a lot more money comes in to fund the business and that can be used to grow the business, continue to expand and achieve its objectives.
Althea: That’s exactly right. It’s a way to open themselves up to new investors, more investors than they would have had before when they were private, basically. And there’s a lot of excitement because investors are getting their first chance to really have, you know, broad access to invest in this company.
Jim: So there are investors prior to an IPO?
Althea: That’s right. Private equity is probably a term that people have heard before. A company that’s starting their business would get investors, but it’s not something that’s listed through a stock exchange. It’s not something that’s open to all investors. And so that’s really what we’re talking about here, is a company moving from maybe a more limited set of investors in their initial startup period to something where it’s more broad. Their stock will be listed on a major stock exchange. Anyone can basically buy it through their brokerage account.
Jim: So there’s limited access for someone like the general public or the average investor to invest in SpaceX prior to it being a public company. And so this is a way to gather those investors to some extent.
Althea: That’s right.
Jim: How would someone participate in an IPO?
Althea: The first way is one you hear about a bit, and I think this is where that question of FOMO comes in—a lot of investors hear about people who are able to participate in the IPO at the initial IPO price. And sometimes it’s unclear who gets to do that and how. So we can explain the mechanics a little bit.
A lot of times these initial offerings are open mostly to institutional investors. However, retail investors, or just individual investors is what we mean, they actually do have access to some of these larger IPOs. You’ve probably read stories about investors being able to request through their brokerage account shares at the IPO price, basically the predetermined price around before that stock starts trading. And a lot of investors are really interested.
We mentioned the hype, the excitement that comes along with these, often in anticipation for really big increases in the share price once a stock starts trading. Often the interest or the demand for these shares can vastly outstrip the supply. What that means is that access is not going to be even for everyone, and everyone isn’t going to get exactly what they want.
You might want a lot of shares of this offering, but it might only be available for institutional investors. You’ve got to usually meet a lot of criteria. It’s basically determined by brokerage firms, who gets that initial access.
Jim: It’s really hard essentially for somebody with a small account or the average investor to actually get the initial shares or a portion of the initial shares.
Althea: That’s right. It’s often very limited. Even larger institutional investors might not get all the shares that they want, and that’s simply because there’s a lot more demand than there is supply.
Often, the initial offered shares are quite small. You see this with SpaceX. They’re offering a very small number of shares given the large size of this company. So as you can imagine, there’s a lot more interest in those shares than there actually is supply of those shares.
Jim: From what I’ve read, there’s actually a larger amount going to the public than typical IPOs. Is that correct?
Althea: That’s right. In fact, in some cases with IPOs—and again, these will vary a lot—but in some cases historically we’ve seen institutional investors be the only ones that are eligible. And in fact, one reason why I think there’s been so much news and kind of regular interest from everyone is the fact that there are individual investors able to go out and through their brokerage account request these shares. These brokerage firms did have requirements around who was able to make those requests. And again, just because you make the request doesn’t mean you get that allocation.
Jim: You mentioned the initial price. How is that determined?
Althea: So there’s a couple different ways. Companies basically can determine this. Oftentimes the price is determined through the offering process. So there’s a period of seeing what type of interest there is. All those institutional investors that we talked about might make their request for a certain number of shares at a certain price, and then the price is often determined through that process.
In the case of SpaceX, that price can also be predetermined and there’s a price at which that offering is made, and then everyone gets to decide how many shares they want to request for that given price. We’ve seen some different examples. But before the stock begins trading, there’s an initial price that that stock is offered at to those initial IPO investors.
Jim: Is that price right?
Althea: It depends. That’s a great question. I mean, at Dimensional price is so important when we think about how to evaluate companies, right? So that price, the way that it is set, the fact that it’s either set by the company or by some kind of process along with bankers and everything… What we do see oftentimes, historically, with IPOs, is the price rise on day one.
I think that’s one reason for that FOMO that you talked about people feeling, is oftentimes what you see is an IPO pop, right? An initial price increase. So whether that initial offering price versus the price you see when the stock begins trading, that’s pretty common and might tell you a little something about what that price is in the offering, right?
Now, I think that this lends itself well to talk about the other common ways that investors are adding this stock to their portfolio, because it’s not just all about the price that the stock begins trading at, it’s also about where it goes from there. And of course, once a stock begins trading, once it makes its initial offering, it’s going to start trading in the marketplace. Investors are going to buy and sell it just like any other stock, and there’s going to be movement in the price over time. That’s another important consideration. A lot of ways that investors who aren’t able to participate in that initial offering or if they maybe didn’t get the shares that they wanted, but they still want to buy that stock, they’ve got to go on the market and buy shares in that company after it starts trading.
Jim: Why not do that? What’s the downside from doing that?
Althea: It’s a great question. Here we’ll touch on indexing and how indexers have thought about it, because I think that is something you hear a lot of news stories about—how different funds are adding that stock. Once that stock is publicly traded, now that access, that ability to buy and sell it on a stock exchange, is there, so really anyone can go out and add it to their portfolio.
You ask why not or why to be considerate about it, and I think this goes back to how Dimensional thinks about evaluating the purchase of really any company, any stock, for our portfolio.
First of all, we want to think about expected returns. So oftentimes when you see new IPOs launch, those stocks might be more expensive. There’s a lot of research that tells us that stocks that are more expensive or on the growthier side versus value, they tend to underperform. So there’s important information that we have about expected returns.
We also know that mega cap companies tend to underperform smaller cap companies. Less profitable companies tend to underperform more profitable companies. So there’s all sorts of characteristics that can tell us about a company in terms of its expected return. That’s going to be really important when we think about why we might want to own a certain company versus another, or how much of it we might want to own.
But there’s another thing that’s really particular to IPOs. Often, there are private investors from before the company went public. There can often be lock-up periods, which is a period of time that an investor is prohibited from selling their shares. As soon as a company goes public, it generates a lot of headlines. You don’t want every investor in your company to suddenly sell their shares. What happens when you’ve got a lot of sellers? The price will probably go down. That’s some bad headlines for that new company, right?
So generally, there will be some considerations on how long investors that were invested in that stock need to keep holding on to those shares. We call those lock-up periods. Sometimes lock-up periods may be expiring during that initial 6 to 12 months of trading. And so that’s one reason why you might see some limitations around how certain investors in those companies can buy or sell their shares, and that might be why a lot of research shows that IPOs tend to underperform other companies during that first 6 to 12 months of trading. So there’s just some important research specific to IPOs around how they perform after that initial first day of trading, and how they perform for that first up to a year of trading on the market.
Jim: So that’s really interesting to me. You’re saying that there’s all these investors that potentially hold these shares, that they can’t sell them right away, and once their lock-up period expires, there’s a good chance that those now go out onto the open market and the market is flooded in a way and the price goes down.
Althea: It can be. It’s just a potential headwind, right? The expiration of those lock-up periods, if you think about the path for some of those investors, they’re going to have kind of an inability to sell their position. Maybe they got in at the ground floor of this investment. The stock went up a lot—you don’t see companies that are failures going out and making public offerings, right? So obviously this was going to be a successful investment for some of those early investors.
So before that company is public, they’re not going to have the ability to liquidate or get that return from that investment they made. So in many cases, those investors might want to sell once they’re able to, which would be when those lock-up periods are expiring.
Again, what we’re talking about here is what the research shows in aggregate. It doesn’t mean every single IPO is going to behave this way. There are going to be case-by-case factors. All of these lock-up agreements and everything are very specific to the individual company, and that’s why it’s important to have the flexibility to evaluate these types of considerations on a case-by-case basis, because they depend on a specific company.
Jim: I remember one of the last big ones was Facebook, and that was a really big, hyped up IPO. That came out and there were all kinds of lawsuits and the price went down significantly but after time, that did really, really well. I don’t remember whether it got that initial pop right away or not, but I know it went down after the public offering and then went up.
Althea: That’s right. Again, this is what we see by and large. We’ve done a ton of research on IPOs, and if you look at them in aggregate, you do see that they tend to underperform other stocks in the market generally for up to a year after trading. And I think a good reason to understand that is likely the expiration of those lock-up periods we were talking about; that is what you see in the data.
Jim: So you can own some shares prior to the IPO and then when the public offering happens, you own shares. You can buy it on the open market if you’re an individual investor and you just want to own some individual shares. But then you can also own it through a diversified portfolio, and you may not even know it.
Althea: That’s right. Many investors are invested in mutual funds and ETFs, so there’s a manager that’s actually making the decision about whether or not to buy this new IPO for the portfolio. A lot of investors own index funds. In that case, the manager is usually going to make the decision based on what the index provider decided to do.
There have been a lot of headlines lately on index providers because they’ve been making announcements about what they’re going to do with this IPO in particular. In the case of many indices, generally they add new stocks to their indices on some predetermined time frame. They might look every single quarter at the stocks that entered the market over the last couple months, and then decide to make them eligible if they meet their eligibility criteria.
A couple things that are unique about this case. Some major index providers decided that they wanted to fast-track or update that process. So rather than waiting for the normal cycle of when they would evaluate and take a look at new stocks that are eligible, they’re going to do it a bit more rapidly—in the next couple weeks, basically. Some indices, not all, decided they were not going to update or change their eligibility rules.
The other thing that comes into play with SpaceX that is really important to remember, is that this company is very large—you’ve seen headlines saying SpaceX’s market cap is now greater than these other big technology names. The amount of shares that it actually offered in its initial public offering was relatively small relative to the size of the company.
So even for indices that are making the decision to add this company to their index, its weight in the index is going to be relatively small because that weight is based on the shares that are available—the public float it’s called—in the market, not necessarily on the size of the company. If only a small proportion of the company shares are actually trading, that’s the proportion that’s going to generally be included in the index. So the weight might be a lot smaller than what some people might expect just based on some of the headlines around the size of this overall company.
Jim: That was actually new information to me. I didn’t realize that. So the indexes can’t determine how much they’re going to buy. They have to do it within their specific guidelines.
Althea: Yes. All these index providers, they have their rule books, they have their guidelines, and those guidelines will say when new stocks are added, and also how they handle questions about how many shares, what’s your proportion of shares outstanding that you need in order to enter the index, for example, or other criteria.
S&P, for example, is pretty famously known for the fact that they usually require four quarters of profitability. That’s something that came into play specifically with SpaceX. Because of course there were a lot of questions around would they decide not to adhere to that requirement in this case, and they have so far announced that they were going to keep that requirement in place.
So I think what all of these announcements from index providers have shown us is that indexing is something with a lot of decisions. Just because there is a rule book doesn’t mean that an index provider can’t come along and say, “I’m going to change this rule and not this rule, and I’m going to fast track this procedure,” where they’re going to change the timeline, for example.
It shows us that there are a lot of decisions being made by index providers that then have impacts for everyone who is invested in one of the funds that tracks that index. Because generally, the folks that are trying to track that index, they want to minimize the difference between that index. So the index says, “We’re going to buy SpaceX shares at the close on this date.” Well, if you’re trying to follow that index, you want to make sure that you’re following it at the close.
And what we’ve seen consistently with a lot of new IPOs is volatility in the share price. If everyone’s trying to buy the same stock at the same time on the same day, generally, that’s going to have an impact on price.
Jim: So let’s stick there for a second. I think this is really important for the SpaceX IPO, and for indexes in general. Can you talk about the impact that has on the price that you just mentioned, this idea that you have to buy at a specific time? Because I know Dimensional does it very differently and this is a very big reason why you guys do it differently.
Althea: Yes, we do. An example we often like to use is, for anyone who’s gone out and tried to buy flowers because they forgot right until Valentine’s Day for their significant other, you’re paying a bit more at the florist, right? You’re paying a premium because you’re buying roses the same day everyone else wants them. Ever tried to get home from New Year’s Eve just after midnight? The Uber surge pricing is huge because everyone else wants a ride at that time. If you’re buying something when demand is high, you’re going to likely have to pay more just because everyone wants the same thing.
We find the same thing is true, and I think it’s one of the pitfalls with indexing when you see how rigid index is about how they buy and sell. Generally, what indices do is they’re going to decide to change their index—sell and buy securities, change the membership in that index—at some predetermined periods of time. That’s the way that they try to keep turnover or a lot of trading low; they don’t trade every single day, right? They keep it to a couple days throughout the year.
They’re going to do the same thing when it comes to these new stocks that are eligible. They’re going to pick a time and say, “On this date, we’re going to add XYZ to our index.” And for anyone that wants to match the index price, they’ve really got to trade at that date and time. The same as buying roses on Valentine’s Day, what that means is you’re going to be buying it when everyone else also is buying it.
We at Dimensional really try to avoid that.
We think that there is tremendous value in having flexibility. When it comes to thinking about how to trade, when to trade, how to use that flexibility, we want to try to avoid trading something at the same time when everyone else wants it, or even having that predetermined time where you say, “Okay, we need to buy all the shares that we want of this company on this particular day at this particular time.”
Our whole process is extremely flexible, so we’re going to go out into the market and look at what stocks we want to buy based on expected return and other characteristics. We’re going to do that throughout the trading day. We’re going to do that on every one of the 252 trading days over the course of a year. If you’re only trading on a handful of them, you’re really concentrating a lot of your activity into just a few points in time, rather than having the flexibility to trade across the entire year.
Jim: So that’s probably what keeps the cost of an index very low is … there’s not a whole lot of work that goes into this. You just set your guidelines and you operate.
Althea: Yeah. As a former portfolio manager at Dimensional, it does sound a little appealing to just get to come into work maybe a couple days a year to trade the portfolio. You know, we often think of indexes as low cost, and I think I’d argue they’re low expense ratio. That number that you see in the prospectus, the expense ratio, is typically pretty low for indexes, but there can be a lot of costs associated with the rigidity of an index approach, with having to follow these rules, having to, you know, trade at some prescribed times in order to match that index. There can be a lot of costs that are built into that type of approach that are just a little bit harder to see and maybe don’t factor into what you see when you’re looking at that expense ratio. So I think it’s really important. There’s value in being able to be flexible with how and when you trade, and that’s a really important part of Dimensional’s approach.
Jim: That’s really interesting. So a lot of retail investors say, “I want the index because the cost is really low.” It might be .03 basis points, but there’s additional costs as you’re describing. There may be some trading costs and other things that it’s harder to see.
Althea: That’s right. We really encourage investors to kind of look under the hood and try to understand what costs might be harder to observe but can be really important and maybe even more meaningful.
The other thing about indexing too is that, you know, you’ve seen just in this case of the announcements of the last couple weeks, indices updating, changing their methodology, their rule decision. Often when we’re buying an index fund, we may not put a lot of rigor or thought into what the index fund manager or index provider is actually doing, but they’re making a lot of decisions that are going to have an impact for investors. And so I think it’s really important that we’re thinking about all those decisions which feel quite active. Making these decisions to say, “We’re going to change our rule set for this company,” for example, or “We’re going to update how we’re doing this.” Those decisions are happening, and it’s pretty important that investors are understanding all the implications for that decision-making too.
Jim: When are you guys going to add SpaceX to your portfolios? I know you’re not going to answer that, by the way.
Althea: No, but I also understand that you’ve got to ask! I mentioned that Dimensional has flexibility, and that we’re going to look at what we care about, our thinking about expected return characteristics. We also think about evaluating these on a case-by-case basis and really understanding when these lock-up periods expire, what do we understand about what the research tells us about expected returns. We’re not going to be swayed by headlines or the decisions of an index provider, for example. We’re really going to take the approach that we take across IPOs.
So while I cannot comment on what we are doing about this specifically, I can tell you that our approach to new IPOs… which happen all the time, right? This is not a new phenomenon. We have our approach that is very much built on applying our flexibility to understand and evaluate companies as they enter the market, and we’re looking at expected return. We’re thinking about these things like the lock-up period expirations, which we know have a headwind on returns, and making that decision.
Jim: I’ve worked with Dimensional for a long time and if there’s one thing I can say, you guys do not get swayed by the hype and the headlines. A very disciplined approach. And it’s not saying you haven’t changed and you haven’t incorporated things, you haven’t evolved over the years, which is phenomenal. It’s just a very thoughtful approach to investing and done with research based on what works as opposed to “in the moment” type of decisions, just because everybody’s doing it.
Althea: That is exactly right, and we’re very proud of that track record, and proud of the fact that we work with partners like yourself that understand why behind that approach.
Jim: And that’s ultimately what leads to a successful investment experience in my mind. So, Althea Trevor, thank you so much for taking the time to speak with us today. It’s really helpful to understand what’s going on in the markets and have you guys as a partner, and allow us a little bit deeper understanding into this SpaceX IPO.
