Swedroe: IPOs Used To Pull In Investors

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.

The Problem Of IPO Flipping
These findings are consistent with those of Jon Christopherson, Zhuanxin Ding and Paul Greenwood, authors of the study “The Perils of Success,” which was published in the Winter 2002 issue of The Journal of Portfolio Management.

They found that “IPO flipping” is most prevalent in the small-cap funds of large fund families. Specifically, large fund families tend to assign a very large portion of their total IPO allocation to one small fund, where it can have a large impact on returns.

Fund families know that if they allocate their share of an IPO to a fund with tens of billions of dollars in assets, the impact on the fund’s return is diluted relative to the impact it would have on a new fund with very little assets. This leads to the allocation of large shares of the IPO to where the impact is greatest (to the detriment of the fund family’s other funds and their investors).

Christopherson, Ding and Greenwood also found another bias in the data—front-running. A large fund family with a small-cap fund has the small-cap fund buy shares of stocks with a low market cap and limited liquidity. Other funds in the same family then pile in, buying more shares. The limited supply of stock allows the large fund family to drive up prices with relatively small purchases by each fund. The returns of the new fund then look great.

The findings are also consistent with those of Jose-Miguel Gaspar, Massimo Massa and Pedro Matos, authors of the study “Favoritism in Mutual Fund Families? Evidence on Strategic Cross-Fund Subsidization,” which was published in the February 2006 issue of The Journal of Finance. They found strong evidence that mutual fund family organizations often play favorites with their funds, strategically transferring performance across member funds, to increase overall fund family profits. Such favoritism can take the form of the selective allocation of underpriced IPOs.

Summary

Chau, Gu and Louca concluded: “IPO allocation is an effective strategy that enhances investment flows during the early months after the inception of a new fund.”

In other words, it’s a logical and profitable strategy for the fund family. For investors, it’s important to understand that, though outperformance related to IPOs is short-lived and the effect dissipates over time, it still lingers in performance data for years to come, luring in unsuspecting investors who believe that past performance is predictive of future performance.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.