Do your clients want to get in on the ground level of the next IPO?

During the Internet craze in the late 1990s, there were a handful of companies designed to deliver the latest and greatest IPO to the doorstep of the individual investor. But since most of those companies were Internet startups themselves, that business model didn’t work out very well.

But now there are a few mutual funds—three, actually, by Lipper’s count — that can bring that same type of investment opportunity to the retail investor more efficiently. They obviously have the advantage of diversification, as do all mutual funds. Jeff Tjornehoj, research manager at Lipper, said that getting exposure to IPOs is safer via a mutual fund so the investor is not so tied to the fortunes of just one or two young companies.

The most recent fund in this group, the Direxion Long/Short Global IPO fund has one more twist that’s interesting. As the name implies, it doesn’t simply buy into IPOs and let them ride. In some cases, it will short the young stocks.

This is in response to the main challenges of investing in IPOs. That is, most new companies don’t continue to dazzle the markets with shoot-the-lights-out performance after the initial offering. At some point, they usually come back down to earth.

The new Direxion fund is sub-advised by IPOX Capital Management and is loosely based on its long/short IPO Index. Here’s how it works, in a nutshell.

The fund segments the lifecycle of an IPO into three phases. The first phase is the actual offering, and often gets the first-day pop that catches the public imagination; for the fund’s purposes, this phase will usually last five to 30 days. The second phase will last for the next 12 to 13 months; during this time the stocks usually continue to perform well, partly due to the fact that there isn’t a lot of information disseminated yet. The third phase, roughly from Year-2 to Year-4, is when the stocks often come down off those previous highs, partly because they now have earnings reports and analysts expectations to deal with.

It’s in this third phase that the fund will sell short. It tries to maintain an equal balance in the investments in the phase 2 (long buys) and phase 3 (shorts). Investments in phase 1 can be up to 20% of the fund, says Paul Brigandi, portfolio manager of the fund.

Andy O’Rourke, the marketing director of the fund, says that it’s new enough that assets haven’t poured in yet because investors often want to see a track record of at least a couple quarters with this kind of venture. But he says that this fund should appeal to investors who want to buy a non-correlated asset.

And in case you think that IPOs are dead, think again. If you look globally, as Direxion does, you’ll see that IPOs have climbed steadily from the lows of 2002. According to Direxion, there were 405 IP0s globally in 2009, even more than the 386 in 2000 or 313 in 1999.

The trend in the U.S. supports the same general story: IPOs in the U.S. increased in the first quarter to 27, up from just two in the first quarter last year.

The other two IPO funds that Lipper tracks are Renaissance Capital’s IPO Plus Aftermarket Fund  and First Trust IPO Index Fund.

The main issue for you, as always, is communicating the risks involved to your clients. They should not just be buying these funds because they want to be part of the sexy story of an IPO. They need to really understand the risks involved and how exactly this fits into their overall portfolio.

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