By, Celine Sun, PhD and Andy Rachleff
The recent introduction of our Single Stock Diversification Service led a number of potential clients to ask what returns they might expect from the average tech IPO. This felt like a perfect topic for our blog to address.
To determine the return of the average IPO we thought it might make more sense to look at a portfolio of all tech IPOs and compare it to the S&P 500, as well as a typical diversified portfolio. Our rationale for these comparisons is pretty simple. We wanted to see if an investor is appropriately compensated for the additional risk she takes by investing in relatively immature companies.
Evaluating IPO Performance From 1990 To 2013
There were 1,218 tech IPOs brought to market between January 1, 1990 and December 31, 2013. In researching these IPOs, we were unable to find ticker symbols for 22, and for 297 out of the group we could not locate price information (both are likely evidence that either the companies in question failed or were acquired for very low prices). This left us with a universe of 899 stocks to analyze.
To evaluate the performance of the IPOs we built a hypothetical portfolio with the following assumptions: We invested an equal amount of money in each of the 899 tech IPO stocks at their closing prices on the first day they began to trade. We chose the closing price rather than the IPO price because it is highly unlikely an individual can buy an IPO stock at its initial offering price. That's because almost all IPO shares are reserved for institutional investors. Next we calculated the time-weighted return for the portfolio because we thought that would provide the best apples-to-apples comparison to the way the S&P 500 return is calculated. We also calculated annual standard deviations for both the portfolio of tech IPOs and the S&P 500 based on their monthly returns. This in turn enabled us to calculate the Sharpe Ratio for each. We calculated Sharpe Ratios in order to measure each portfolio's risk-adjusted return. The Sharpe Ratio divides a portfolio's excess return over the risk-free rate (the 3-month treasury bill rate) by its standard deviation.
The 899 tech IPOs had a much higher annualized return than the S&P 500. This is consistent with what we would have expected because tech IPOs are a higher risk investment than the U.S. stock market in general - and higher risk usually commands a higher return. However, the risk-adjusted return of the tech IPOs was much lower than the S&P 500, almost 1/3 lower (0.27 versus 0.39 for the S&P). This clearly proves the point that investing in IPOs is not worth the risk.
Evaluating Tech IPOs Against a Diversified Portfolio
For further perspective we thought it might make sense to compare the tech IPO portfolio to a classic diversified portfolio as represented by the average Wealthfront portfolio (i.e. one based on an average Wealthfront risk tolerance of 7 on a scale of 0 to 10). We needed to look at the performance of the tech IPO portfolio and the S&P 500 since January 1, 1998 because that is the first date we have index data available to calculate what the Wealthfront portfolio would have returned if it were available. Limiting the time frame to 1998 through 2013 further reduced our tech IPO sample to 653 companies. The following table presents the return analysis for the shorter time period:
Again, not surprisingly the tech IPO portfolio generated a higher nominal return than the S&P 500, but a much lower risk-adjusted return (0.16 vs. 0.21) due to its far greater volatility (standard deviation). Also not surprisingly, the Wealthfront portfolio generated a risk-adjusted return well in excess of either alternative. It was somewhat surprising that the Wealthfront portfolio generated a higher nominal return than the S&P 500 given its lower risk (volatility).
Adjusting for the Bubble
Critics might point out that the period from 1998 to 2013 includes the bursting of the tech bubble in March 2000, which could have significantly influenced the outcome of this analysis. In order to address this concern we also looked at the nominal and risk-adjusted returns for all three portfolios from January 1, 2001 to December 31, 2013. Limiting the time period reduced our sample of IPOs to 205 companies.
Once again the tech IPO portfolio produced the worst risk-adjusted returns and the Wealthfront portfolio produced the best risk-adjusted returns. You might be surprised to find that the tech IPO portfolio's nominal return underperformed the S&P 500 during this period. Perhaps the underperformance can be explained by the removal of the incredible returns during the highly speculative tech bubble of the late '90s.
Our Analysis Overstates IPO Returns
I think it's safe to say based on this analysis that investing in a general basket of tech IPOs is not a good idea. As a matter of fact we believe our analysis overstates the performance of the tech IPOs because it includes significant survivorship bias. It is highly likely that the vast majority of the 313 companies we had to remove from our analysis due to lack of ticker symbol or pricing information underperformed the remaining tech IPO portfolio.
No matter how you look at it, you are unlikely to be adequately compensated for taking the risk associated with an investment in a broad basket of tech IPOs. A great deal of attention has been paid to the big IPO winners, but unfortunately the number of losers far exceeds the number of winners. We hope you think twice before jumping in to a buy a recent IPO. The odds are certainly not in your favor.
Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. Financial advisory services are only provided to investors who become Wealthfront clients. To achieve the hypothetical Sharpe Ratios described here, we measured returns for three portfolios for the time periods discussed: A hypothetical portfolio of tech IPO stocks, the S&P 500 Total Return, both of which consists of one asset class, and a Wealthfront taxable portfolio, consisting of six asset classes, with a risk score of seven. For the Wealthfront taxable portfolio we did not consider the affects of rebalancing, dividend reinvestment or advisory fees. We assumed the "risk free rate" to be the three-month Treasury bill rates. After we measured the simulated historical monthly returns of the investments over the periods, we were able to calculate the Sharpe Ratio for each portfolio. This hypothetical calculation does not take into consideration the effect of taxes, changing risk profiles, or future investment decisions. This simulation does not represent actual client accounts and may not reflect the effect of material economic and market factors. The results are hypothetical only. The results of this simulation should not be relied upon for predicting future performance and is not a guarantee of actual performance. A different methodology may have resulted in different outcomes. For example, we assume that an investor's risk profile and allocation would not have changed during the time period shown; however, actual investors may have experienced changes to their allocation plan in response to changing risk profiles and investment objectives. Furthermore, material economic and market factors that might have occurred during the time period could have had an impact on decision-making. Actual investors on Wealthfront may experience different results from the results upon which we based our calculations. While the data used for its historical simulation are from sources that Wealthfront believes are reliable, the results represent Wealthfront's opinion only. The return information uses or includes information compiled from third-party sources. Wealthfront does not guarantee the accuracy of the information and may receive incorrect information from third-party providers. Unless otherwise indicated, the information has been prepared by Wealthfront and has not been reviewed, compiled or audited by any independent third party or public accountant. Wealthfront does not control the composition of the market indices or fund information used for its calculations, and a change in this information could affect the results shown.
Celine is Wealthfront’s research scientist and works on a wide range of projects and in-depth quantitative data analysis. She applies her econometric expertise to developing and improving investment strategies and research infrastructure. Among Celine's other work prior to joining Wealthfront was a stint as an intern at Parametric Portfolio Associates where she formulated tax sensitive trade strategies, performed scenario analysis and built a tax-managed portfolio simulator in R. She earned her PhD in Financial Economics from the University of Washington where she also earned her MBA and Computational Finance Certificate. She received her MS in Statistics from Syracuse University and BS in Mathematics from the University of Science and Technology of China.
Andy is Wealthfront’s Executive Chairman. He serves as a member of the board of trustees and vice chairman of the endowment investment committee for University of Pennsylvania and as a member of the faculty at Stanford Graduate School of Business, where he teaches courses on technology entrepreneurship. Prior to Wealthfront, Andy co-founded and was general partner of Benchmark Capital, where he was responsible for investing in a number of successful companies including Equinix, Juniper Networks, and Opsware. He also spent ten years as a general partner with Merrill, Pickard, Anderson & Eyre (MPAE). Andy earned his BS from University of Pennsylvania and his MBA from Stanford Graduate School of Business. He has frequently been named to Forbes magazine’s The Midas List as a top tech venture investor.