Some IPOs Actually Work for Investors
Research has shown that investing in IPOs has been a bad deal – you lose money compared to a comparable index fund. But a new paper shows that certain VC-backed IPOs deliver alpha for investors.
Many investors think that initial public offerings (IPOs) are both exciting and rewarding – especially when familiar brands become broadly available to investors for the first time (such as Uber, Lyft, and Beyond Meat). And classical economic theory suggests that because they are riskier, IPO investors should expect higher returns as compensation. However, defying both investor expectations and economic theory, there is a large body of evidence from around the globe (as detailed in my Nov. 14, 2022, Advisor Perspectives article) demonstrating that unless you are sufficiently well connected (to a broker-dealer who is part of the issuing syndicate) to receive an allocation at the IPO price, IPOs have generally underperformed appropriate risk-adjusted benchmarks, and by wide margins.
Dimensional studied the performance of IPOs over the period 1992-2018 and found IPOs generated an annualized compound return of 6.93%, 13.63%, and 3.74% over the full, initial nine-year, and final 18-year sample periods, respectively, as compared to 9.13%, 15.70%, and 5.98% for the Russell 3000 index over the same time horizons. In comparison to the Russell 2000 Index, the hypothetical portfolio of IPOs underperformed in the overall period (6.93% vs. 9.02%) and the 2001–2018 (3.74% vs. 7.29%) subperiod and outperformed (13.63% vs. 12.56%) over the period from 1992 to 2000. The evidence is why Dimensional generally excludes IPOs from their funds.
Two explanations have been offered for this anomaly – the lottery effect (investors prefer positive skewness in returns and are willing to accept a high probability of a below-average return for the small chance of earning an outsized return) and the winner’s curse (in an auction, like an IPO, where we assume the average bid, reflecting the collective wisdom of the crowd, is accurate, the winner, making the highest estimate, is likely to have overpaid).