Investment in IPOs through Mutual Funds. Should you do it?

Prabhat Nigam

09 Dec, 2021

The pandemic has exposed us to financial insecurities and financial instability. In order to never face such financial crunch again, people have become wise with their money management choices and started investing handsomely in the stock market. The most common investment patterns observed in inexperienced retail investors is making their investment in IPOs.

With increased participation of the retail investors in the stock market, the influx of IPOs has increased simultaneously. But, with most of the Initial Public Offerings (IPOs) getting oversubscribed the retail investors do not get the share they applied for. The investment firms not wanting to let go this opportunity have started their own IPO mutual funds.

Going by the success of some of the IPOs providing great results, the retail investors have started investing in the IPOs indiscriminately and made it some form of speculation rather than making their decisions on the basis of strong market research.

Though the craze of the investors is high, but due to oversubscription most of the times fail to get a share and those who do get it, they get only a fraction of the share that they applied for.

What is a Mutual Fund?

A mutual fund is an investment vehicle managed by an expert fund manager that invests its pooled funds in a variety of securities such as stocks, bonds, debentures etc. according to the predetermined objectives of the fund and the investors who have pooled in the funds derive profits and losses keeping in mind the stated objectives of the fund.

What is an IPO?

IPO is an acronym for Initial Public Offering. It refers to the act of a private company becoming public when the private company offers its shares to be purchased by a range of investors which includes institutional investors, high net worth individuals and retail investors. It is usually a very long and tedious process which involves a host of underwriters, merchant banker, stock exchange etc.

Reasons for making investment in IPOs through Mutual Funds

Rather than going solo without consultation, investing in IPOs thorough Mutual Funds is a better option.

1. Due Diligence done by Mutual Fund: The mutual fund has a big team of area specific experts and professionals having years of experience in the stock market. They have a big research team and other resources at their disposal to make important strategic decisions. The level and precision of due diligence done by this team would be far superior to the decisions made by an inexperienced retail investor forming decisions on the basis of market hearsay only. This becomes a prime reason to make investment in IPOs thorough mutual funds.
2. Mutual Funds are far more equipped to get subscription than retail investors: There are better opportunities for the institutional investors to get hold of the subscription compared to the small scale investments done by the retail investors. In order to meet the prescribed subscription the companies launching their IPOs sell huge chunks of their IPO shares at lucrative prices to these institutional investors. So, it is even more attractive for retail investors to route their investments through the institutional investors in order to have an upper hand of their investments compared to retail investors. Research has shown that the IPOs where institutional investors made their investments have proven to grow higher at the rate of one percent per month and the IPOs where the institutional investors have invested less have not shown such great returns. This proves that the institutional investors have the eye for better performing IPOs while the retail investor bears the brunt of underperforming IPOs. Further, the companies in whom institutional investors don’t invest at the stage of their IPO then at the later stages also institutional investors don’t invest in them all the way making more sense for the retail investors to make investments in IPOs through mutual funds.
3. Power to drive market sentiments: Institutional investors have the power to drive the market sentiments and attract other institutional investors to make investments in IPOs. Presence and Absence of a strong backing from the institutional investors^[1] can be responsible for the possible success or failure of the IPOs. Therefore, the companies try to attract the institutional investors at lucrative prices.
4. Exit from the holding: A normal tendency of the retail investors is to dilute their holdings at the early stages of listing. It can be at the time of listing of the shares or within a week of listing. Due to this immaturity from the investors’ standpoint they tend to lose from the future possible gains. At other times when the investors do not see early profit, they dilute their holdings where they could have gained since some of the companies tend to make profit at later stages. In order to save the investor from such losses, an expert advice or opinion must be taken. And what better than institutional investors with years of experience can bring to the table.
5. Diversification of risk: Moving the investment of mutual funds in IPOs also gives the opportunity of diversification of risk which ultimately defends the investments of the investor in case some of the IPOs do not perform as per the expectations. Such window of diversification of risk is not present in case of retail investors due to small capital outlay. Investing through the mode of Mutual Funds will help the small retail investors to make their investments in the shares of multiple IPOs. 

What should be looked for while making Investment in IPOs through Mutual Funds?

Nowadays many companies are coming up with their own IPOs especially the loss making internet based ones. Now the question arises whether it is feasible for the Mutual Funds to make investments in IPOs of such companies.

To answer the above problem there cannot be a straight jacket formula to find out which ones to choose and which ones to reject. However following factors can be of certain help while making the above decision:

1. Good track record of the performance of the fund: if the fund has performed very well especially around forty percent of annualised returns in the past three years, then it becomes a good proposition for the retail investor to invest in a mutual fund that makes investment in IPOs.
2. Other factors that must be taken into account while choosing a company’s IPO for investment is the policy and objectives of the company, the expertise and experience of the management of the company and the most important one being the valuation of the company. If the company has set the valuation of the IPO unreasonably high, then it can raise eyebrows of the investors and they may refrain from making investment in IPOs.
3. However, there has been a trend where the fund managers have made investments in the loss making companies and yet it was observed that the share prices have risen over a period of time. There can be multiple reasons for the same for example the company could be the market leader or the first mover. Further, though the company may not be profit making but if the market share and growth that the company has taken in the past few years is extraordinary, fund managers’ investment in IPOs of the company and the share price will continue to rise.

Conclusion

Earlier, loss making companies were prevented from coming up with their IPOs but later such restriction was taken down and the Mutual Funds resorted to make investment in the loss making IPOs. Even though the restriction on the investment in the loss making IPOs has been taken down, barring few exceptions, it hasn’t served much benefit to the loss making companies to raise money from IPOs thorough the Mutual Fund investors. The reason behind is the conservative behaviour of the fund managers since they are entrusted with the money of the public. The fund managers do not find interest in making investments especially in the loss making companies. Another reason could be that such companies take out their IPOs in the initial stages of the growth and the company hasn’t fared through the tough business cycles and the ups and downs in the business. These are the reasons why the record of mutual funds in the IPOs has been very minimal in the past years. But, given the years of experience that the fund managers have in the industry in making investments, it is always a better option for the retail investors to make investments in mutual funds investing in IPOs because of the advantages of due diligence, huge resource base, diversification of risk and the ability to drive the market sentiment in favour.

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