The asteroid cometh: Whether IPO underpricing is being exploited by hedge funds

Abstract

Underperformance of initial public offerings (IPOs)- a minuscule return following initial period of drastic appreciation after their issuance- is one of the remaining mysteries of quantitative finance. The size of the implied underpricing of new issues arguably should attract many a hedge fund to participate. On the contrary, the fraction of hedge funds investing in IPOs is rather small; their longevity is short and their performance decent, but hardly spectacular. In this article, I use a Markov growth-collapse model to explain the phenomenon of the finite growth of an asset, which may exhibit explosive returns punctuated by a rare devastating event. The proposed reason for the fact that hedge funds investing in IPOs never achieve the performance implied by alleged astronomical IPO underpricing is that one especially large and unsuccessful investment can obliterate the bulk of the gains. © 2011 Macmillan Publishers Ltd.