There is considerable drive by regulators towards the power of transparency, and that shining a light deep into superannuation funds is empowering to fund members.
In line with this key theme, we recently ‘lit up’ the world of large superannuation fund investing to test the power of transparency on one area of Australian equity portfolio management – participation in initial public offerings (IPOs). The headlines and hype around IPOs may lead a superannuation fund investor to think it is a brightly-lit area. But there is considerable murkiness in the way IPO results are calculated and, in particular, what it really costs a fund to have an equity manager chase extra returns through IPO participation.
Our study sought to isolate the value an equity manager could have added through institutional bookbuild IPO participation, net of costs, across 2011-2018. We created a hypothetical large-cap Australian equity portfolio which, as a base case, participated in every IPO in the Australian market between 2011 and 2018 and received a fair (rather than preferential) allocation. The results were underwhelming, adding on average around 3.5 basis points each year to investment performance, before costs.
Is there value in superior IPO selection or better access?
Australian equity managers can be quick to assert that they can beat this ‘base case’ market experience and add value to their clients’ equity portfolios by cultivating relationships with lead IPO managers (brokers). This can lead to two sources of value-add: superior selection of IPOs and a preferential (better than fair) allocation of IPO stocks. Without individual managers sharing their data with us, we could not test whether a specific Australian equity manager can really add value to large superannuation fund portfolios through IPO participation. But scenario testing our hypothetical large-cap portfolio led to some interesting observations.
A key finding is that IPO participation pay-offs have a hidden cost attached which are rarely included in calculations of IPO value-add.
The costs are in the form of directing trade volumes (‘flows’) to specific brokers and paying higher than execution-only brokerage rates on equity trades, day in and day out. This is a kind of investment to cultivate the manager’s relationship with the broker – using the client’s investment capital – with the hope that, amongst other things, the manager can benefit when IPO deals come along from superior selection (judging which IPOs to participate in) and from receiving a generous allocation of the IPO stocks pre-listing day from the broker.
The costs of buying favour with a broker
That daily favouring of particular brokers instead of simply pursuing lowest-cost best execution on every equity trade costs more than one might think. Over our analysis period, brokerage rates on large-cap equity trades averaged 10-20 basis points (0.1% to 0.2%), while execution-only brokerage was available at 5 basis points (0.05%). For a $1 billion actively-managed superannuation equity portfolio with modest 50% one-way turnover each year (100% two-way), the manager’s alpha-chasing ‘round trips’ cost the fund $1-2 million in brokerage instead of $500,000 each year. That difference is quite a ‘bogey’ for IPO participation to beat. At a minimum, it is essential to capture some of these higher trading costs in any calculation of IPO participation pay-off.
Capturing these costs, a manager who is twice as good at choosing IPOs or securing access as the market (our base case) is still, after costs, only able to advance the portfolio by about 5 basis points (0.05%) a year. The manager has to be at least four times better than the market to even get the performance contribution from IPO participation into double digits (10 basis points or 0.1%); five times better lifts the value of IPO participation only to 12.5 basis points (0.125%) annually.
While every basis point of return counts, shining a light on this aspect of equity investing suggests a reality quite different from the hype that surrounds IPOs.
Declining opportunity set
We are nervous about the value of IPOs as an opportunity set, given how seasonal and unpredictable it is, not to mention the interesting U.S. trend for companies to shun public markets for capital raisings. Industry predictions are for ‘slim pickings’ for IPO deals in 2019 in Australia. This means even a manager with the best IPO selection skills securing the best allocations simply cannot add value when there is little company appetite to raise public funds.
There is an alternative, solid path for managers to pursue on behalf of their large superannuation fund clients. They could adopt, as a default position, simple, nuts-and-bolts best execution and transactional efficiency, without favour or generosity to any particular broker, every day on every equity trade. This opportunity set is always available and has pay-offs that are transparent, measurable and consistent.
We do not rule out the prospect of some managers (especially in the small-caps space) harvesting sizeable returns through IPO participation. But we see IPOs as another area that needs to be brightly lit, to empower large superannuation funds and other investors to look behind the headlines and hype to determine where the true value lies.
Raewyn Williams is Managing Director of Research at Parametric Australia, a US-based investment advisor. This is general information only and does not consider the circumstances of any investor. Additional information is available at parametricportfolio.com.au.