Larry Swedroe explains why IPOs don't offer a lot of rewards for average investors.
Larry Swedroe, Director of Research, The BAM Alliance
IPOs involve a great deal of uncertainty, which makes them risky. Thus, investors expect higher returns as compensation for the higher risk. However, there is a large body of evidence that demonstrates 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 underperformed the overall market.
Latest Research
Daniel Hoechle, Larissa Karthaus and Markus Schmid contribute to the literature on IPO performance with their March 2017 paper, “The Long-Term Performance of IPOs, Revisited.” Their original data set consisted of U.S. companies going public between January 1975 and December 2014.
After applying several screens (such as depositories, real estate investment trusts, closed-end funds, partnerships and low-priced stocks), the final sample consisted of 7,487 IPOs. While prior studies looked at the returns of IPOs in the first few years, Hoechle, Karthaus and Schmid analyzed IPO performance over varying time horizons, ranging from one to 40 quarters.
Following is a summary of their findings:
The authors reported other interesting findings:
Hoechle, Karthaus and Schmid concluded there’s a “statistically significant and economically meaningful underperformance of IPO firms over time horizons of up to two years even when the usual risk factors are accounted for.”
They found this to be the case even after controlling for the new factor of investment—low-investment firms outperformed high-investment firms. Also of interest, they found that firms underperform when they are aggressive in terms of acquisitions.
Clearly, IPO investors were not rewarded for taking risk. So what’s going on? The literature suggests two explanations. The first is the lottery effect.
The Lottery Effect
It’s well-documented that investors prefer “skewness” in returns—they’re willing to accept a high probability of a below-average return for the small chance of earning an outsized return (e.g., if they find the next Google). This is what’s often referred to as the “lottery effect.”
The second explanation is referred to as “the winner’s curse.”
The Winner’s Curse
Eric Falkenstein explains the winner’s curse in his book, “The Missing Risk Premium: Why Low Volatility Investing Works.” Let’s say you have to guess the number of jelly beans in a jar. If you compute the average of all the guesses of a large crowd, it’s usually very close to the actual number. While some of the individual guesses are off by a wide margin, the lowest guesses offset the highest guesses.
Now imagine this group in the context of an auction. The result of averaging the maximum prices everyone would pay for an item should be a very close approximation of the item’s true value.
However, that’s not the way an auction works. The person who wins the auction is the one with the highest bid, which is obviously higher than the average price (or approximate value of the item), meaning the person will almost certainly overpay.
With a stock, some investors will perceive its value as higher than the market price and others as lower. That balance is what gives a stock its price. However, IPO stocks may not have that same balance, for a few reasons:
As a result, the optimistic investors are the ones driving prices, causing the initial jumps associated with many new stocks. “The wisdom of crowds” applies to the average (mean) guesses of, say, the weight of an ox, or how many jelly beans are in a jar. It turns out that, while there are large errors, they tend to be randomly distributed (both high and low). If the average guess is truly the best estimate, the highest estimates are biased upward.
The term “the winner’s curse” was coined in the 1950s to describe the fact that, for auctions of oil fields, the winners were generally cursed by winning (if the average bid was closest to the best estimate of the correct value, the winning bid was too high). The same principle can apply to stocks, especially in cases where it’s difficult for arbitrageurs to drive the price back to its “true” value, as with IPOs.
The combination of the winner’s curse and the preference for skewness can explain not only the poor performance of IPOs but also the poor performance of small-cap growth stocks, penny stocks, stocks in bankruptcy, high-beta stocks and seasoned equity offerings.
Summary
The bottom line is that when it comes to IPOs, despite their higher risk, unless you’re well-connected enough to get an allocation at the IPO price (the average IPO tends to jump on the first day), the returns have been poor.
As Richard Feynman, one of our most famous theoretical physicists, said, “It doesn’t matter how beautiful your theory is, it doesn’t matter how smart you are. If it doesn’t agree with the experiment, it’s wrong.”
This commentary originally appeared May 3 on ETF.com
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2017, The BAM ALLIANCE
Not all annuities are created equal. Joe Delaney on avoiding the ones that don't fit your needs.
Joe Delaney, Lifeguard Wealth, San Rafael, CA
Too often, I’ve heard this all-too-familiar story. A client brings in an annuity policy to review, either for themselves or a family member. They bought it to create a steady annual flow of income on later life, as insurance against unexpected longevity.
But what we see is a jaw-dropping set of numbers that reveal poor performance, high commissions paid to brokers, misleading benefits and ridiculously high expenses. Unfortunately, too many investors purchase an expensive annuity that doesn’t fit their needs.
How do so many fall into this trap? There are a few key reasons.
Great for the Seller: Commissions
As an investor, the first thing to be wary of is the possibility that a broker, or agent, is pointing you in the direction of a product that’s in their interests more than yours. Exhibit A is the annuity. An insurance product rather than a securities package, annuities are sold by insurance agents rather than brokers. It is sometimes the best option an insurance-only agent (not securities licensed) can offer.
There is nothing wrong with selling annuities, nor is there anything wrong with insurance agents earning commissions. However, when a product has particularly high commissions, it is all the more important to ask the agent directly whether annuities are in your best interests.
Strictly speaking, agents don’t have to act in your best interests because they are not subject to federal fiduciary rules that govern financial advisors. They also pay out among the highest commissions in the financial service industry. The highest rates are paid for longer surrender periods, years during which policy holders are charged for withdrawals above the approved limit.
With so many common options that benefit the seller at the expense of the buyer, it can be tempting for unscrupulous agents to speak to the benefits of annuities while omitting the risks.
Stability for the Buyer
The main benefit of the annuity is the option to guarantee a minimum return. Investors tend to fixate on the apparent risk-free nature of annuities as they plan to enjoy fixed payments after a pre-arranged waiting period.
In reality, this describes just one type of annuity, a fixed annuity. Similar to a Certificate of Deposit (CD), investors sacrifice the potential for a higher rate of return for the guarantee of a smaller one. Unlike a CD, there are generally complex fees and conditions attached to fixed annuities that reduce the value of the annuity.
For example, while tax is deferred as your annuity is accumulating, once you begin to withdraw accumulated funds you’ll have to pay taxes at your ordinary tax rate rather than the lower, applicable, long-term capital gains tax rate. (If you invested $100,000, your annuity grows to $150,000 and you’re in the 35 percent tax bracket. You’ll pay 35 percent on the first $50,000 you take out, 20 percent more than on capital gains at 15 percent.)
More Complex Options May Increase Return
Other types include indexed annuities and variable annuities. These appear to offer the potential for higher returns: indexed annuities because the rate of return is tied to a specific market benchmark, such as the performance of the S&P 500; variable annuities because they allow premium payments to be reinvested, somewhat like a mutual fund.
Unfortunately, these types of annuities often have performance caps to offset the risk the firm takes on by guaranteeing a performance floor. These can significantly reduce expected returns. Participation rate is another factor that limits what investors earn, as it governs what share of returns go to the firm and what share goes to the annuity holder. (For example, a 70 percent participation rate means if the market gains 10 percent, your gain is 7 percent while the firm keeps 3 percent.)
The above limitations on rate of return don’t take into account the additional premium investors must pay for riders to secure some of the benefits of these annuities, which further reduce actual return on investment.
Bottom Line: Insurance, Not Investment
Annuity performance often pales in comparison with a balanced portfolio of stocks and bonds, yet we routinely hear of “new and improved” annuities that insurance agents counsel clients to convert into, via a 1035 tax-free rollover. That only serves to fatten the agent’s wallet while further locking up a client’s ability to earn real income.
The good news is investors are starting to wise up to this. Annuity sales saw a 17% drop between Q4 2015 and Q4 2016. (It is still a $51 billion industry. So, investor beware.)
Does all this mean that you should definitely not purchase an annuity? No. What is important to understand is that while an annuity can act as a hedge against running out of income as you live longer, it is not the same as an investment portfolio geared toward the best possible return at the lowest possible expense.
Be cautious, and always speak with an advisor bound by a fiduciary obligation to act in your best interests before you purchase any kind of annuity.
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2017, The BAM ALLIANCE
Make your money serve your life, not the reverse. Manisha Thakor on why that means knowing what we truly want.
Manisha Thakor, Director of Wealth Strategies for Women, The BAM Alliance
Align your financial reality with your drivers of happiness. Manisha Thakor on a simple exercise to help you start creating tighter linkages between your money and your life so that the former serves the latter, not the reverse.
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2017, The BAM ALLIANCE