Investing in Initial Public Offerings (IPOs) | Summary and Q&A

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December 7, 2019
by
Ben Felix
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Investing in Initial Public Offerings (IPOs)

TL;DR

IPOs are often underpriced and getting an initial allocation is difficult, leading to poor expected outcomes for retail investors. IPO firms tend to underperform in the first two years.

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Questions & Answers

Q: Why are IPOs underpriced?

IPO underpricing occurs because the underwriters set a price below where the market will likely price the shares. This creates a perception of an opportunity for investors to make a quick profit on the first day of trading.

Q: Why is it difficult for retail investors to get an initial allocation in IPOs?

The majority of the initial allocation typically goes to institutional investors, while retail investors, especially those without significant assets or revenue generation for brokerage firms, have a lower chance of participating.

Q: Do new mutual funds benefit from IPO allocations?

Yes, new mutual funds often use their institutional status and relationships to obtain IPO allocations as a strategy to boost their performance initially and attract new investors. However, their performance tends to decline after the first six months.

Q: Should investors buy shares on the secondary market if they miss out on the initial allocation?

Buying shares on the secondary market means investing in firms that tend to behave like small growth, low profitability, and high investment stocks. This type of investment often has an unattractive risk/return profile.

Summary & Key Takeaways

  • IPOs are frequently underpriced, creating an opportunity for investors to make a quick profit on the first day of trading.

  • Getting in on the initial allocation of an IPO is challenging, as the majority goes to institutional investors or larger brokerage clients.

  • New mutual funds leverage their institutional status to participate in IPO allocations, potentially boosting their performance initially, but it tends to drop off quickly.

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