3 Caveats to Consider About Investing in IPOs

When a private company decides to offer equity ownership shares to the public, this is called an Initial Public Offering, or IPO. It is an exciting time for the company and its original private shareholders. The public often gets excited too, especially when it’s a well-known company.

Is all the excitement worth it? IPOs do tend to be initially underpriced. So, if you can get in on the ground floor – that is, with an allocation in the initial offering before the stock starts trading – there is evidence you are likely to profit. This might make IPOs seem like easy money, but there are at least 3 crucial caveats to consider first. Once I go over them, you’ll realize why investing in IPOs isn’t expected to live up to the hype.

Caveat #1: It Is Very Hard To Get in on the Ground Floor

Again, it is well-documented (such as here and here), that IPOs tend to be underpriced. When the underwriter determines the price at which the company should offer its shares to the public, the data show that they tend to set a price below where the market will price the shares. This creates the perception of a real opportunity for all sorts of investors to make a quick profit on the first day of an IPO. Perpetuating this perception, the media often reports on the large first-day profits the earliest IPO investors have made.

But there’s that crucial caveat: Getting in on the initial allocation is really, really hard for most investors. The overwhelming majority of the initial allocation goes to institutional investors. And the remaining, much smaller allotment for retail investors is likely to mostly go to larger brokerage clients.

Fidelity describes the allocation process for retail investors as follows:

“Each customer who wants to participate in an IPO offering is evaluated and ranked based on his or her assets and the revenue they generate for their brokerage firm. Typically, customers with significant, long-term relationships with their brokerage firm will receive higher priority than those with smaller or new relationships.”

Fidelity’s description is supported by a 2018 Journal of Finance paper, “Quid Pro Quo? What Factors Influence IPO Allocations to Investors?” Its authors examined 220 IPOs from January 2010–May 2015 to identify IPO allocation determinants. They found strong support that the brokerage revenues associated with a client was a significant determinant.

**Caveat #2: If You Can Get in, You Had Best Wonder Why**

Unless you are a high-value brokerage client or an institution, Caveat #1 sets the stage for Caveat #2: If you are able to get in on an initial allocation, you are likely getting in on a poor expected outcome. There is adverse selection in IPO allotments, where those with expected weak first-day returns have been easier to access ahead of time.

In other words, I think it’s safe to say that smaller retail and do-it-yourself investors who are not generating significant revenues for their brokerage firm will be hard-pressed to get in on a promising initial allocation from a hot company going public. And it stands to reason, you probably don’t want to get in on the rest of them.

Interestingly, there is evidence that new mutual funds use their institutional status and relationships to get in on initial IPO allocations to boost their early returns. This was detailed in the 2017 paper “IPO Allocations and New Mutual Funds” by Frankie Chau, Yi Gu, and Christodoulos Louca. They looked at data from 1998–2015, and found that new mutual funds tended to outperform during the first 6 months after inception. This outperformance was concentrated in new funds that held underpriced IPO stocks.

But then, after the first 6 months, performance fell substantially. The authors suggested fund companies might choose to allocate all of their IPO allotment to a new fund, to jumpstart its performance and attract new investors. While this might generate an initial boost, fund performances under these conditions tended to drop off quickly.

This demonstrates the level of competition for initial IPO allotments. But before you conclude it might make sense to speculate on new mutual funds in an effort to profit, remember: It is only easy to identify funds that have received preferential IPO allocations after the fact – i.e., after the boost has come and likely gone. This brings me to my third point.

Caveat #3: Close Enough Isn’t Good Enough

So, you’re probably not going to get in on the initial allocation when a company goes public. But you may be wondering whether you could still do well by buying in on the first day of trading. Once the shares are listed on a stock exchange, many of the people holding the initial shares will want to realize the quick profit they’ve made from their likely underpriced IPO. Couldn’t you be the one to buy them out?

The performance of IPOs after the first day of trading has also been studied extensively. In a March 2017 paper, “The Long-Term Performance of IPOs, Revisited”, Daniel Hoechle, Larissa Karthaus, and Markus Schmid detailed the performance of U.S. IPOs between 1975–2014. They looked at a total of 7,487 IPOs over periods ranging from one quarter to 40 quarters after the first trading day.

They found that IPO firms tended to behave like high-beta stocks with negative loading to the value factor. They typically underperformed for the first two years, even after accounting for common risk factors like size, relative price, and momentum. This underperformance gradually declined with longer time periods, becoming statistically insignificant after two years.

In 2019, Dimensional Fund Advisors published a paper in which its authors examined 6,362 U.S. IPOs between 1991–2018. To evaluate IPO performance, they constructed a hypothetical market-cap weighted portfolio of IPOs issued over the preceding 12-month period, rebalanced monthly … but excluding first-day returns. In other words, the portfolio reflected the experience most investors could reasonably expect to have by investing in IPOs.

Over the full sample period, the U.S. IPO portfolio returned 6.93%, with a standard deviation of 27.62%. The Russell 3000 index, a U.S. total market index benchmark, returned 9.13%, with a 14.28% standard deviation.

Dimensional also split the full sample period into two sub-periods. One of them ended in the year 2000, to isolate the high volume of IPOs from the 1990s. Both sub-periods before and after 2000 exhibited underperformance relative to the market, with substantially more standard deviation risk. This result corroborates the findings of Hoechle, Karthaus, and Schmid, who found that IPOs performed poorly for the first two years.

The Dimensional paper also applied the Fama/French five-factor model to the IPO portfolio’s returns. They found the returns were well-explained by the model factors: market beta, company size, relative price, profitability, and investment. As a group, IPO firms behaved like small-cap growth stocks with weak profitability and a high level of investment. Whether or not they are recent IPOs, these types of stocks have tended to underperform the market.

If You Are Not a Major Player, Avoid Striking Out

What can we conclude? Most of us face three strikes as potential IPO investors.

Strike one: If you want to make money from IPOs, you have to get in on the initial allocation. But especially for hot IPOs, it’s unlikely you can get in this early unless you are one of your broker’s top clients.

Strike two: Based on this reality, if you are able to get in on an initial allocation, there’s a good chance it’s not an IPO that will have a big first-day pop.

Strike three: If you miss the initial allocation and instead buy shares on the secondary market, you are buying shares in a company that is expected to perform like a small-cap growth firm with low profitability and high investments. That’s an unattractive risk-return profile.

I have not even gotten into the downsides of concentrating your investments in single stocks instead of diversifying across their asset classes. Unless you are building a diversified portfolio of recent IPO stocks, your actual outcome on individual stock investments will be driven by the specific risk of each company. This delivers a random outcome at best.

Have I made myself clear? IPOs may seem exciting, but they’re a game in which the odds are probably stacked against you. The best way to “win” is to take your investments elsewhere.