The Evidence-Based Investor

How funds use IPOs to inflate performance

Posted by Robin Powell on March 15, 2017

As every TEBI reader knows, plain and boring, fuddy-duddy index funds are by far and away the best investment vehicles for long-term investors to use. But whether it’s cars, tech, fashion or investing, most of us prefer products that are shiny and new, and the fund industry knows this only too well.

Larry Swedroe wrote an excellent post for ETF.com the other day in which he explains how fund houses use initial public offerings, or IPOs, to make their latest products look, erm, rather better than they really are.

Swedroe cites a study published last month called IPO Allocations and New Mutual Funds, which looks into the inclusion of IPO stock in newly created funds between 1998 and 2015.

The authors begin by stating that the literature shows that mutual funds have preferential access to IPOs and that the typical IPO is substantially underpriced.

Briefly they found that:

  • • new funds generally outperformed more established funds;
  • • the average alpha created in the first six months was positive and statistically significant; but
  • • the amount of declined substantially from 8.0% in month one to 1.6% in month two;
  • • new fund outperformance was concentrated among funds that held IPO stocks; and
  • • performance then fell substantially.

 

To quote Larry: “The lack of persistence indicates that the results were not skill-driven. Instead, they were a result of the fund family allocating their share (or a large portion) of the IPO to the new fund in order to enhance its performance and attract investor inflows.”

These latest findings are consistent with those of a study called The Perils of Success, published in 2002, which explored the phenomenon of “IPO flipping”, whereby large fund families tend to assign a very large portion of their total IPO allocation to one small fund, where it can have a big impact on returns.

Such tricks work wonders for the fund family, in that they inflate the performance of new funds, thereby attracting larger inflows and generating more in fees. But investors need to know that the distortion effect of IPOs wears off over a very short period of time, and those exciting new funds you read about in the media are usually not that special after all.

 

You can read Larry’s article here:

IPOs used to pull in investors

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Robin Powell

Robin is a journalist and campaigner for positive change in global investing. He runs Regis Media, a niche provider of content marketing for financial advice firms with an evidence-based investment philosophy. He also works as a consultant to other disruptive firms in the investing sector. Regis Media.

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