Diversification is key to steady returns but how you diversify is just as important, says James Sore, Chief Investment Officer at Syndicate Room.
Interest rates are at a historic low, UK gilts yields continue to fall and property – both commercial and residential – is under pressure. In this unstable environment, more and more investors are beginning to look elsewhere to grow their finances.
To find it, they’re going to have to move up the risk curve for a chance at higher returns meaning the percentage of portfolios that include EIS and VCT investments and the weighting those investments hold within these portfolios will only increase.
EIS investments are often uncorrelated to main market movements, at least on a day-to-day basis. They also come with significant risk-reducing tax reliefs and high potential returns, and as such offer an attractive investment opportunity for investors.
Fintech companies have been breaking down barriers to entry and increasing the sophistication of access to retail investors, and financial advisers are also becoming more comfortable with the inclusion of EIS deals in portfolios. But what’s the best way to navigate this investment landscape and what should you think about when selecting an investment strategy?
The finance free lunch
The Nobel Prize-winning economist Harry Markowitz famously once said:
‘Diversification is the only free lunch in finance’
It’s a wonderfully satisfying soundbite, but what exactly does he mean and how should we interpret this statement in order to inform investment decisions and maximise returns?
Building a broad portfolio of investments of different stages, liquidity, sectors, sizes and types reduces the chances of having highly correlated investments within the portfolio, where macro changes such as housing market changes, unemployment or general market performance can affect all investments in the same way. Having an array of different types of investments also allows for a balance of risk and returns which should be in line with your overall investment risk profile. The higher-risk end of your portfolio should include some earlier-stage equity investment exposure, especially if you are not approaching retirement.
Simply diversifying by buying a smaller stake in a number of deals can potentially reduce your risk exposure compared to investing larger amounts in a smaller number of companies; that much is obvious. The problem is that to diversify, as an isolated investment strategy, is not all that is needed. What is important is to also make sure the underlying investments are of the highest quality.
Buying a diverse selection of rotten vegetables doesn’t magically make them fresh again.
Investors should always be searching for ways to improve their odds of success. This can be achieved in two ways:
- Train to become a proficient investor and select the very best deals yourself, or
- Follow professional investors or investment strategies and invest alongside them through the various products available.
Going it alone
Deciding to become an angel investor is not a decision to be taken lightly, but for those that become proficient there are massive potential returns to be made.
Going it alone means you will source, price, negotiate and invest in the companies you chose. Berkshire Hathaway’s Vice Chairman, and arguably one of history’s most successful investors, Charlie Munger stresses the importance of knowing the businesses you are considering investing in – really knowing them, the market, their competitors, their plans and achievements made to date. The more you know about the business, the closer you can get to accurately assessing its intrinsic value and not its stock price, which is often a very poor mechanism for valuing a business.
If you then discover an investment that is trading at a significant discount to its intrinsic value (this can be the public or private price being offered), you can decide to invest. This discount between the market (offer) price and intrinsic value is essential as it gives you a margin of safety for the inevitable ups and downs in the price of that investment.
Follow the leader
These two pieces of investing advice do somehow seem to be competing requirements:
‘Diversify your portfolio’ and ‘Know your sector’
Investing in private companies is difficult. There is a huge level of choice on offer, and to really ‘know’ the vast array of sectors required to build that diversification takes a huge amount of time, dedication and, well, knowledge. You wouldn’t be alone in asking, how can I diversify outside of my knowledge base confidently enough to invest? Well, just as Aristotle, Confucius and Socrates all believed, real knowledge is knowing the extent of one’s ignorance; it is vital to know the limits of your knowledge and invest accordingly.
If you wish to invest in discrete investments but do not have the time, knowledge or connections to source, price, negotiate and invest in the opportunities yourself, you can invest alongside other angel investors in a syndicate. However, care should be taken as to how best to gain exposure to these investment opportunities. One option is to invest alongside angels on an investor-led® platform such as SyndicateRoom, which offers you the same share class and price as those experienced investors leading the rounds.
If, however, you are looking to gain exposure to a market but do not feel you have the knowledge, time and interest to select and build your own portfolio, investment funds offer a compelling option.
Funds offer investors access to a wide range of investments focused on delivering risk-adjusted returns. Whether actively or passively managed, all funds seek to diversify by holding many tens of investments in a portfolio.
Exchange traded funds (ETFs) have become extremely popular because they are transparent, offer significant levels of diversification, have low fees and provide retail investors access – something that was previously reserved for the very wealthy but is now accessible to near all. ETFs offer a diverse selection and construction of investments from a single investment into the fund. Active funds aim to beat the market by generating returns that exceed overall market returns.
When deciding whether to choose a passive or active managed fund, returns should always be compared after fees and expenses. When this is performed, passive funds often outperform actively managed money. Charlie Munger recommends having a selection of long-term ETFs, a passive product, and leaving them alone, as the practice of frequent rebalancing can erode returns due to the fees associated.
Options for passive investors to diversify in the early-stage space are quite limited. It’s possible to invest in an actively managed EIS fund, but such funds usually only invest in between five and eight investments each and are generally single sector. One option would be to invest in a number of such active EIS funds, but the minimum investment per fund often exceeds £25,000, sometimes climbing as high as £100,000, which means you would have to commit hundreds of thousands each year.
I find this lack of diversification and low portfolio size very strange. Yes, these high-risk investments have the potential to yield high returns, if low levels of liquidity, and yet the number of investments per fund is lower and spans fewer sectors which increases your risk exposure.
It’s this counter-intuitive behaviour that drove us to build the first passive EIS fund, Fund Twenty8.
Fund Twenty8 offers early-stage investors the benefits of an ETF-style approach to passive fund management, multi-sector exposure and a portfolio approach where we guarantee at least 28 investments per fund. Each investment is led by an angel, syndicate or professional investment fund and Fund Twenty8 invests alongside them, benefiting from their knowledge and experience. You can find out more information about Fund Twenty and other products we offer at www.syndicateroom.com.
