Venture capital is a terrible asset class. It has underperformed small cap stocks, is subject bubbles and trendy fashion, and is often available in dangerous investment vehicles. Investors who want to speculate on the little guy or be part of the next big thing should just focus on established micro cap and small cap stocks or buy shares of Google (GOOG). Either of these options is preferable to investing in new ventures.
Micro cap and Small Cap Beats Venture Capital
The Kauffman Foundation's report on the past 20 years of venture capital returns notes that small cap stocks have outperformed venture capital. That's right, boring small caps. In fact, Kauffman found that only four out of thirty venture funds in their portfolio beat a small cap index. Their venture investments delivered lower returns with more risks like liquidity risk, less diversification (firm-specific risk), and the risk of higher fees (legal, etc.) which are sometimes incurred when liquidating a private investment.
Instead of venture capital, it would be prudent to invest in small caps. One attractive small cap value fund is the Rydex ETF Trust S&P Smallcap 600 Pure Value (RZV) ETF which features a low average price-to-book ratio, low fees, and a low average market capitalization in its holdings. Small cap core exposure can be achieved with the iShares S&P Small Cap 600 (IJR) Index or the Schwab U.S. Small-Cap (SCHA) ETF, each of which provides investors with a solid portfolio while charging low fees.
Investors in these funds may reap the small cap premium, the historical trend for stocks with smaller market capitalizations to create greater returns than those with larger market capitalizations.
Google is Also Optimal to Venture Capital
Some people invest for bragging rights that small caps and micro caps don't deliver. This isn't a smart thing to do with your money, but there are ways to minimize the damage this psychological disorder will do to you. You could buy shares of Google. This is a very cool stock with established operations, actual sales, earnings, and cash flows. It's not a great value for your portfolio, but it's cool. Buying shares of Google as a venture capital surrogate is like using a nicotine patch instead of smoking: It's not healthy, but healthier.
Why is Google cool? It is pursuing myriad different ventures including its own smartphone operating system, social media platform, a smartphone mounted on eyeglasses, and self-driving cars. These projects are in various stages of maturity, from roll-out to open-source collaboration with third-party developers. Recently, California recently joined Nevada as the second state to license the use of driverless cars on public roadways. The new law officially allows Google's prototype of a self-driving car on the roadways as long as there is a licensed human driver inside of the car to take over if something should go wrong. Pretty cool, right?
Venture Capital as an Asset Class
There are many reasons to stay away from the entire venture capital asset class. It seems like the army of well-paid entrepreneurs, investment managers, consultants, and attorneys enjoy spending venture capital while investors suffer low, often negative returns. My impression of venture capital comes from experience writing business plans, helping run a business plan competition, and listening to scores of talks by venture capitalists. I can honestly say that despite all my experience, none of my concerns have been assuaged.
Worse yet, my anecdotally-inspired fears have been confirmed by the extensive experience of thoughtful pension fund managers. The Kauffman Foundation reviewed venture capital fund performance and found that VC funds underperformed the stock market since the mid-nineties. After considerable study of their 20 years of data, Kauffman's Chief Investment Officer, Harold Bradley is highly skeptical of VC. He rejects the notion that pension funds should have any required allocation to startups. In a Bloomberg interview, he suggested that institutional investors should only invest in the top 10 VC funds and avoid the vast majority of other funds. He said, "If you can't be with those 10, the only way to win is not to play."
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