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IPO investing made easy for individual investors

Alibaba IPO NYSE
Adam Jeffery | CNBC

There's little doubt that the recent IPO of Alibaba, the giant Chinese e-commerce site, has put the initial public offerings market in the spotlight once again. With its $22 billion debut on the New York Stock Exchange on September 19, the company became the largest IPO in history, beating Visa's $17.9 billion offering in 2008. Alibaba's shares surged 38 percent to close its first day of trading at $93.89. On Friday, the stock closed at $90.23 a share.

So what does all this mean for retail investors? It's always been difficult for individuals to get shares in a much-anticipated IPO. Indeed, retail investors were able to get their hands on just 10 percent of the shares in the Alibaba deal—and more than half of those went to family, friends and employees of the company. Financial institutions received the vast majority of the shares in the offering and will continue to buy in the aftermarket.

But there are other ways for individual investors to participate in the market for newly public companies. One avenue is through exchange-traded funds (ETFs) that specialize in the space. Two of the most well known are First Trust U.S. IPO Index Fund (FPX) and Renaissance IPO ETF (IPO).

Kathleen Smith, a principal with Renaissance Capital and a global IPO investment advisor, said its ETF invests in newly public companies with at least $100 million in market capitalization. Each holding in the ETF remains in its index for two years.

Read MoreAlibaba opens at $92.70 per share

The ABCs of ETFs

"An ETF takes the emotion out of IPO investing, while giving an investor exposure to the market for newly public companies," said Smith, noting that her firm's ETF is able to buy shares of newly public companies five days after they begin trading. That means investors don't benefit from any potential—and often much anticipated—first-day "pop" in a company's share price. But still, she said, it's "a less risky way of being in this space compared to an investor buying shares of a solo IPO, which may be hard to come by anyway."

Jay Ritter, a finance professor at the University of Florida who has analyzed data on thousands of U.S. IPOs, said the offering price of any one IPO can be misleading. For those retail investors who were able to get in on the Alibaba deal, the risk becomes: will the company's stock continue to rise after its first day of trading or, as was the case with Facebook, will the share price tumble for months before recovering? "The offering price of an IPO is not a reflection of supply and demand of that company's stock," says Ritter. "The price is based on an insufficient supply of those shares set by the underwriters."

Read MoreMore companies offer IPO shares to customers, fans

Renaissance Capital's top ten list of upcoming IPOs

Estimated IPO
size ($mil)
Company
Business description
$2,500 Paramount Group Largest REIT IPO ever with top quality office towers
$1,000 LINE Japanese messaging app with 470 million users
$1,000 Fairmont Santrol Largest supplier of sand for well fracking
$1,000 Cnova French and Brazilian e-commerce firm
$750 Shell Midstream Shell's MLP of its Gulf Coast pipeline assets
$750 Dianping Chinese Yelp-like website
$500 Lending Club Peer-to-peer small loan website
$350 Wayfair Home furnishing e-tailer
$100 Shake Shack Hamburger Fast food chain with 51 locations
$100 Hubspot Cloud-based marketing automation software
Source: IPO ETF manager Renaissance Capital

According to Renaissance Capital, there will be no shortage of IPOs for the remainder of the year. Despite recent gyrations in the stock market—including last Thursday's 264-point drop of 19 percent to 16,945.80—the firm predicts that 286 companies will raise $80 billion through IPOs in 2014, up 46 percent over last year and the most proceeds since 2000. More than half the deals in the pipeline are coming from biotech and health-care companies, although there are a few consumer-related offerings, including home furnishings e-tailer Wayfair, and hamburger chain Shake Shack (see chart).

"Only a prolonged stock sell off would derail IPO activity at it's current pace," Ritter said.

While comparisons between today's strong IPO market and the one that existed prior to the dotcom bust are inevitable, Ritter says there are major differences that make today's climate less risky. "In the late 1990s, the majority of the companies going public were young, unproven, and priced at stratospheric valuations," he says. These days, the majority of the companies going public have proven business models and the deals are getting done at more reasonable prices.

Read MoreInitial Public Offering: CNBC Explains

"Alibaba is a prime example," Ritter says. "It has $8 billion in sales and has been around for 15 years. No one is wondering if this company is going to be in business in a few years."

Smith says a shift in investor sentiment also distinguishes today's IPO environment from the frothy climate of 1999 and 2000. "Back then, investors were much more interested in buying individual equities and that extended to IPOs," she says. Today's retail investors are much more likely to be doing their equity buying through funds and indexes. "Given what happened in the dotcom era and in 2008, financial advisors are afraid to be stock pickers," she says. "There's a different mentality out there when it comes to risk."

That doesn't mean that any of the ETF funds out there should command an overwhelming percentage of an investor's equity allocation. Smith recommends that an IPO ETF as a sleeve in an equity portfolio, comprising anywhere from 5 percent to 10 percent. For individuals who want exposure to the newest of the new, investing in IPO ETFs is a less risky way to get in on the ground floor.

—By Susan Caminiti, special to CNBC.com