Few industries have been as tribal and opaque as venture capital. For years, the VC world was a mystery to outsiders, with its language and customs. But in recent years, there has been a growing effort to make the industry more transparent.
A recent study published by the National Bureau of Economic Research (NBER) sheds new light on how VC fund of funds outperform the market and reduce risk. The study found that the average VC fund funds generated net returns that outperformed the S&P 500 and Russell 2000 PMEs.
VC Outperforms Public Markets
Today's stock market is in a record bull run, but that doesn't mean there aren't risks. Many experts believe we are overdue for a market correction.
After all, periods of exuberance in public markets are punctuated by years of lethargy as performance reverts to the mean. For instance, in the decade after the dot-com crash, the PME index annual return dropped to 0.08%, while private equity maintained a 7.5% average.
This is because VCs are more likely to invest in companies with high potential growth. As the NBER study confirms, company-level returns within a specific VC fund follow Pareto's Principle: 20 percent of the companies within a fund generate 80 percent of returns.
In other words, VCs are more likely to generate returns by investing in a small number of high-growth companies. This is why VC funds outperform the market during bull markets and experience less severe corrections during bear markets.
Moreover, it’s not just top-quartile VC funds that outperform the market. The NBER study found that “VC funds in the 2nd quartile also have PMEs above 1.0, overall and for both pre-2001 and post-2000 vintages.” This means that, on average, you are better off investing in a mediocre VC fund than a publicly-traded market index.
VC Fund of Funds Reduce Risk
The premise of diversification is simple: don't put all your eggs in one basket. And yet, many investors still don't diversify their portfolios enough.
One way to diversify is to invest in a VC fund of funds. These investment vehicles invest in various VC funds, reducing the risk of any fund underperforming.
The NBER study found that the average VC fund of funds outperformed the market by a wide margin. Not only have buyouts “consistently outperformed public markets with the average PME being 1.20 across the sample,” but “VC funds, overall, also have out-performed public markets with the average PME of 1.22 across the sample.”
This is likely because these vehicles have access to a large pool of capital and can invest in more companies than most individual investors.
In addition, VC fund of funds are more likely to generate returns by investing in a small number of high-growth companies. VC investing is risky at the company level, but it is lucrative at the portfolio level.
The Bottom Line
The NBER study reiterates what many experts have long known: venture capital is a smart investment strategy for those who can stomach the risk. For those who want to reduce their risk, investing in a VC fund of funds is an ideal way to diversify your portfolio and get exposure to the top performers in the industry.
But what about the average investor? Can they still benefit from this strategy? The answer is a resounding yes. With a Gridline Thematic Portfolio product, you can invest in 5 to 10 institutional-grade VC funds for just $100,000. This allows you to achieve the same level of diversification and exposure to top performers as the wealthiest individuals and endowments.
So don't miss out on this opportunity to supercharge your portfolio. Invest in a VC fund of funds today.