Mutual Funds, Index Funds, or VC Funds?

Over the last few years there has been an ongoing dialogue amongst pension funds on whether or not actively managed funds are better than passively managed funds. This has been an ongoing topic in the pension world for several years now. Having observed and participated in these conversations I have noticed there are usually two sides to this argument: On the “pro” side there are fund managers who believe that actively managed funds are the only way to create “Alpha”, and there is the con side that believes that net of fees, actively managed funds are no better than passive funds (i.e. Index Funds). Right or wrong, I’d like to share my thoughts on this topic, and integrate my thoughts on how investing in venture capital fits into the mix.

I was looking at a recent investment report for our pension fund and I noticed that net of fees, there were several active fund managers that underperformed their benchmark in the last 10 years. “How can this be?,” I wondered. Perhaps, if the markets are truly efficient and each active fund manager has access to the same public information, then maybe this explains why the returns aren’t significantly better than the market. Or maybe, if management fees were lower then active fund manager’s performance might appear a lot better.

So then, if investors can’t capture much excess alpha because of fees, then what other options are there? One option is investing in private equity and/or venture capital. Venture capital funds are advantageous because unlike the public stock market, it is not “efficient,”  meaning that everyone does not have access to the same information. When an investment is made into a venture capital fund the advantage or disadvantage relies primarily on the general partners (GPs) who individually select, develop, and build new companies. GPs have full discretionary authority to invest how they please and they do not have to share much detail about how or why they do what they do. Of course, GPs provide reports and updates to their investors, but outside of what they provide, there is no public database of information for open review.

Over the last 25 years, Early Stage venture capital funds returned 30.1% IRR versus 9.5% IRR for the S&P 500 (source: NVCA 2Q2015 report). While the long-term returns are great, one potential disadvantage of venture capital is illiquidity. Illiquidity can be an issue for some investors, hence the reason why most investors will not allocate a large majority of their assets toward venture investing. Most institutional investors (pension funds, etc) will allocate a small percentage (3% to 7%) of their overall portfolio to alternative investments, which usually includes some small allocation to venture capital.

The job fund managers face in delivering excess alpha in today’s environment is becoming increasingly difficult. In my opinion, I think competing on alpha is too hard and diminishes the true value that active fund managers bring to the table which is  guidance and information. There is such a tremendous amount of complicated investment jargon and market news out there that it’s nearly impossible for the average person to keep pace. The true value-add is when a fund manager can condense all of the market noise into a concise and easy form so that investors are educated, fully aware, and feel like they’re getting value out of what they’re paying for.

One of the advantages of investing in venture is not everyone can invest in it. Not surprisingly, one of the disadvantages of investing in venture is also not everyone can invest in it. There are two reasons for this: first, the majority of people don’t understand the nature of venture investing; and two, the Securities and Exchange Commission (SEC) has placed restrictions on who’s permitted to invest in non-publicly traded companies. The SEC does however permit “qualified investors” to do so.  A Qualified Investor is also referred to as an Accredited Investor, which can either be a qualified institution or a high net worth individual. For the sake of not boring you with all the details, I’ve supplied a link to the SECs website so you can read it yourself.

Placing restrictions on who is allowed to invest is necessary. Even though some non-accredited investors might understand the nature of investing in early-stage ventures, many of them cannot afford to invest in such a risky asset class. In addition, because investing in early-stage venture is illiquid in nature, non-accredited investors usually don’t have enough capital to diversify adequately across the asset class to produce the yield necessary to make it worthwhile.

Luckily, there is a way that the average-joe can invest in venture. As written on the SEC website: “On April 5, 2012, the Jumpstart Our Business Startups (JOBS) Act was signed into law by President Barack Obama. The Act required the SEC to write rules and issue studies on capital formation, disclosure, and registration requirements. Under the Securities Act of 1933, the offer and sale of securities must be registered unless an exemption from registration is available.  Title III of the Jumpstart Our Business Startups (JOBS) Act of 2012 added Securities Act Section 4(a)(6) that provides an exemption from registration for certain crowdfunding transactions. In 2015, the Commission adopted Regulation Crowdfundingto implement the requirements of Title III. Under the rules, eligible companies will be allowed to raise capital using Regulation Crowdfunding starting May 16, 2016 (Source: https://www.sec.gov/spotlight/jobs-act.shtml).” For newer information on the rule check our FINRA as well.

To put all of this in “plain-speak,” it means that now non-accredited investors can invest (within certain boundaries) in non-publicly traded companies without the need for meeting the stringent income requirements that were previously required. As a result of these changes a number of online brokers have emerged such as MicroVentures and WeFunder (Disclaimer: I have no affiliation with either of these companies nor do I endorse either of them – They are merely examples). I don’t have a full picture on how active crowdfunding platforms have been over the last few years, but I would guess not a lot of people are aware of it. Not many people understand venture investing in general because they aren’t familiar with the life-cycle of early-stage companies and due to the high failure rate, they’re unsure how many companies they need to invest in to create a diversified portfolio. As more and more people learn about venture, and we have more time to flush out returns, investment allocations to the sector are likely to grow.

In 1976, the founder of Vanguard Group, John Bogle, created the first index fund. After being fired from Wellington, a banking an investment firm, John was influenced by a paper written by Paul Samuelson that outlined how active fund managers performed no better than the stock market. My Samuelson went on to say that he hoped that one day in the future someone if someone were to create an index fund it would further validate his thoughts on the matter. So John did just that.

After John went to market the first index fund, there was an uproar in the industry and everyone thought it was a stupid idea and no one would ever invest their money into something like that. In fact, upon initially taking the fund to market John only raised 8% of his $150 million target! Even his underwriters at the time told him to give up and move on. Was he discouraged by this? No. He knew that over time people would see the light and come to his side of the tracks. Since that time, Vanguard has garnered over $4 trillion in assets under management representing nearly 20% of the market capitalization of the New York Stock Exchange.

I certainly believe that active fund managers add value, but the value they provide is not just in producing returns, but in providing guidance, feedback, and advice. With the rise and popularity of Index Funds investors are seeking yield in other areas, hence the growth in alternative investment within investment portfolios. As more and more non-accredited investors learn about investing in venture and the regulations continue to loosen for who can invest in the space, it’s likely more and more people will view venture an asset class that might complement their investment portfolio. Whether it’s comprised of all active or passive index funds or not. Cheers -KM.


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