Despite the evidence showing that past performance is a poor predictor of future mutual fund performance, mutual fund families know that a majority of investors believe this is not the case. Mutual fund families exploit that lack of knowledge, not only by charging high fees for actively managed funds that underperform an appropriate risk-adjusted benchmark, but in an way that most investors are likely unaware of.
During the bull market period 1998 through 2000, 1,337 new mutual funds were created. During that same period, 1,139 IPOs occurred. On the other hand, during the financial crisis from 2008 through 2010, only 138 new funds were opened. And only 153 IPOs occurred. Is the correlation of new fund offerings and IPOs a coincidence? Or is there something else going on?
Evidence Of Exploitation
Frankie Chau, Yi Gu and Christodoulos Louca, authors of the February 2017 study “IPO Allocations and New Mutual Funds,” present evidence demonstrating that mutual fund families are exploiting the lack of sophistication of most investors. Their study covers the period 1998 through 2015.
The authors begin by pointing out that the literature shows both that mutual funds have preferential access to IPOs and that the typical IPO is substantially underpriced. Their study goes on to investigate whether new mutual funds take advantage of such IPO-related opportunities for trade to generate superior performance. Following is a summary of their findings:
- Using the Carhart four-factor model (beta, size, value and momentum) to measure risk-adjusted performance, new funds outperformed more established funds.
- During the six-month period after inception, the average alpha was an annualized 3.94%. The alphas were also consistently positive and statistically significant.
- The magnitude of alphas declined substantially from 8.0% in month one to 1.6% in month two—the outperformance was relatively short-lived.
- The outcome was indifferent to whether the fund was managed by an individual or a team.
- New fund outperformance was concentrated among funds that held IPO stocks, particularly highly underpriced IPO stocks.
- Afterward, performance fell substantially.
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. This effect was found among both large and small fund families, although it was more prevalent among younger fund families.