Behavioral finance is a fascinating field that combines psychology with investing. And one of the insights provided from the research is that some individuals want more from their investments than just returns.
Some people make investments for the same reason they buy Rolex watches and oversized Gucci bags, labels proudly displayed. Just like with their “accessories,” these individuals want their investments to convey status, wealth and sophistication.
I believe it is the need or desire to be a member of an exclusive club that explains why people invest in hedge funds, even though—as we have so often shown—their historical results are horrific.
I also believe that the same need or desire helps explain much of the popularity behind investing in venture capital. While its results have, in general, been much better than those of hedge funds, venture capital hasn’t delivered greater risk-adjusted returns than publicly available equities of similar risk, such as small-value stocks. Consider the following evidence.
In 2000, venture capital funds collectively raised a record $105 billion, making it a blockbuster year for the industry. But how did their investors fare during the subsequent period? London-based alternative asset research firm Preqin studied the returns from 100 venture capital funds launched in 2000.
For the funds they examined, Preqin found that the median internal rate of return was a negative 0.3 percent. For the period from January 2000 through October 2010, the S&P 500 Index returned -0.2 percent. Thus, the median venture capital firm slightly underperformed. However, the S&P 500 is not an appropriate benchmark.
The Right Benchmark
When we compare the returns from venture capital to more similarly risky, and publicly traded, small value stocks, we see a much difference picture. Over the same period, the MSCI Small Value Index returned 9.6 percent per year. What’s more, publicly traded small-value stocks lack the liquidity risk that comes with an investment in venture capital.
This result is nothing new. Other studies have found similar results. For example, according to Venture Economics—a provider of information and analysis on the venture capital industry—private equity overall returned 13.8 percent for the 20-year period that ended June 30, 2005. For the same period, small-cap value stocks returned 16.0 percent.
Another study, which covered the period from 1974 through 1989, found that the average internal rate of return from venture capital was 13.5 percent. This was well below the return of 23.7 percent for small-value stocks.
Looking At Research
More recently, a 2014 study—“Private Equity Performance: What Do We Know?”—found that while the median private equity fund outperformed the S&P 500 index by 3 percent a year, small-cap value stocks returned an annualized 16.0 percent, outperforming riskier private equity by 2.2 percentage points. Data in the study covered the period from 1984 through March 2011.
The bottom line is that there is a compelling argument indicating the returns earned by venture capital investors haven’t been fully commensurate with the risks involved. Private equity investors forgo the benefits (liquidity, transparency, broad diversification and access to daily pricing) enjoyed by mutual fund investors. And in addition, private-equity investments often entail long lockout periods during which investors cannot access their capital.
Given the evidence, it appears the real winners from venture capital investments were the sponsors of venture capital funds. They collected large fees (typically 2 percent per year and at least 20 percent of profits) regardless of whether their funds delivered on their “promise” of market-beating returns. As a result, investors seeking higher returns, and not just a status symbol, should consider publicly available small-value funds rather than venture capital.
Larry Swedroe is the director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.