While the media focuses on first-day pops, the structural reality of initial public offerings leaves retail investors with either the leftovers or a long-term drag on their portfolios.
The Allure of the First-Day Pop
An Initial Public Offering is a milestone for any successful private company, marking its transition to the public stage. For the investing public, it is often viewed through a lens of excitement and the promise of quick profits. This enthusiasm is not entirely unfounded; data consistently shows that IPOs tend to be underpriced. When underwriters set the initial offering price, they frequently do so at a level below where the market is expected to trade, creating the potential for a significant price jump—the "pop"—on the first day of trading.
To the casual observer, this looks like easy money. If you can secure an allocation at the offering price before the ticker hits the exchange, you are statistically likely to see an immediate gain. However, this perceived opportunity ignores the gatekeepers of the financial system. The gap between the offering price and the first-day market price is a value transfer, and the financial industry has a very specific hierarchy for who is allowed to capture that value.
The Gatekeepers and Adverse Selection
The primary challenge for the individual investor is that getting an allocation is remarkably difficult. The lion's share of any hot IPO goes to institutional investors. The remaining sliver reserved for retail investors is not distributed democratically; instead, brokerages like Fidelity openly admit that they rank customers based on assets and the revenue they generate for the firm. If you are not a high-value client with a long-standing relationship, you are at the back of the line.
This creates a classic problem of adverse selection. If an IPO is easy for a small retail investor to access, it is often because the institutional giants didn't want it. Evidence suggests that when you do manage to get an allocation, it is likely for an offering with weak expected first-day returns. In the world of IPOs, the deals you can get are the ones you probably don't want, and the deals you want are the ones you can't get.
Manufacturing Performance in Mutual Funds
Even the professional management space uses IPOs in ways that can be misleading for investors. Research has shown that new mutual funds often use their institutional status to secure IPO allocations specifically to juice their early returns. This "incubation" strategy allows a fund company to funnel underpriced shares into a fledgling fund, creating an impressive track record during the first six months of its existence.
This outperformance is rarely sustainable. Studies indicate that after the initial six-month window, the performance of these funds tends to drop off substantially. While this tactic helps fund companies attract new assets by advertising high inception returns, it serves as a warning to investors: the early success of a fund driven by IPO allocations is a structural quirk of its institutional access, not a signal of long-term managerial skill.
The Secondary Market Slump
Most investors who miss the initial allocation decide to buy shares on the first day of trading. At this point, the "easy money" has already been made by the insiders and institutions, and the retail buyer is providing the liquidity for those initial holders to realize their profits. Unfortunately, the long-term data for buying IPOs on the secondary market is grim. A study of nearly 7,500 US IPOs between 1975 and 2014 found that these firms tend to underperform the broader market for the first two years of trading.
This underperformance persists even when accounting for common risk factors. While the negative effects eventually become statistically insignificant after two years, the early years of a public company’s life are often characterized by high volatility and disappointing returns. Investors buying into the hype on day one are frequently entering at the peak of the company's valuation relative to its near-term fundamental prospects.
The Factor Profile of Failure
When we look at IPOs through the lens of factor investing, their poor performance becomes easier to explain. Research from Dimensional Fund Advisors shows that as a group, IPO firms behave like small-cap growth stocks with weak profitability and aggressive investment strategies. In the world of financial science, this is a notorious "black hole" of investing. Historically, small growth companies that spend heavily but earn little have delivered some of the worst risk-adjusted returns in the market.
Between 1991 and 2018, a hypothetical portfolio of recent IPOs returned roughly 6.9%, while the total US market returned over 9%. More strikingly, the IPO portfolio was nearly twice as volatile. You are essentially taking on significantly more risk for a lower expected return. Unless you are building a vast, diversified portfolio of these stocks—which most individuals are not—you are also exposing yourself to the idiosyncratic risk of a single company, which is more akin to gambling than disciplined investing.