FAIRNESS IS THE PRINCIPLE THAT MATTERS MOST TO ALL

Large Cap, Small Cap and Two Guys in a Garage Cap
July 3, 2000

The world of investing is full of stories of feast or famine. Of investors who put their money into certain sectors of the market and made a fortune and others who were not so lucky, and those who made a fortune on a stock market tip only to lose it all.

As any financial advisor will tell you, trying to time the market is extremely difficult. The odds of being spectacularly successful are very low. And is the gamble really worth the headache? Many investors must be asking this question now that the equities markets are becoming less forgiving. With sensible diversification that reflects your own personal tolerance for risk, however, investing doesn't have to be such a roller coaster ride.

What is diversification?
Simply put, diversification is not putting all your eggs into one basket. It is an insurance policy against a poorly performing investment. Most commonly, this involves placing your assets in a number of different types of investment. Broad diversification would involve holding large cap stocks and smaller cap stocks, growth and value stocks, some foreign equity exposure, and, depending on your attitude towards risk and how near to retirement you are, some exposure to the bond markets. "Accredited investors" - wealthier investors, institutional investors and pension funds - have also long been able to use additional diversification tools such as hedge fund and venture capital fund exposure.

How diversification benefits the average investor?
It is easy to become side tracked when a particular asset class is performing well and place all your investments in that one class, but what works one year may not work the next. A diversified portfolio ensures that an investor spreads his/her exposure to such risk.

To illustrate this point, investors who placed all their assets in a S&P 500 Index Fund at the beginning of 1999 based on that market sector's outperformance in 1998, would have missed out on the resurgence of the emerging markets, and the strong performance of the technology and global telecommunications sectors. Likewise, an investor with all his/her assets in Internet stocks or Internet focused mutual funds may have made money in 1999 but would have seen those gains eroded in the first half of 2000, and may even have lost money depending on when the initial investment was made. An asset allocation in a different market sector would have helped to offset such volatility, effectively smoothing returns.

Where does a venture capital fit into this picture?
Since venture capital funds invest in privately owned companies, their performance isn't as closely linked (correlated) to the fortunes of the stock market as an equity or mutual fund investment would be. This means that, unlike other riskier investments such as incubator companies and hedge funds, the returns of VC funds may not necessarily experience any impact if stock market performance is volatile.

At this point it would be worth comparing such riskier investments and the degree to which they represent a useful diversification tool.

• Traditional venture capital funds - These funds generally have a life of about ten years. Fund holdings usually remain private for a number of years following the initial investment. During this time, the venture capital firm becomes directly involved in the management of these companies, offering industry expertise and advice, and helping to patiently build value in the company before either taking it public or selling its stake. Only the most successful investments are taken public, the majority are either sold to or merged with other companies.
• Incubators - Publicly listed incubators are a relatively recent phenomenon spawned by the growth of the Internet and Internet companies. The most well known include CMGI, and Internet Capital Group (ICG). CMGI specializes in investing in and bringing to market business-to-consumer (b-to-c) and business-to-business (b-to-b) Internet companies, and ICG's focus is on b-to- b Internet companies. These companies have some similar traits to venture capital funds in that they invest in start-up companies, but they are not directly comparable. Their holdings tend to be more focused on a particular market segment and are taken public at a far more rapid pace than more traditional venture capital fund investments. Incubators also continue to hold publicly traded stock in many of their investments for longer than a traditional VC fund would. As a result, their fortunes tend to be far more tied to the performance of the stock market and the IPO market than traditional VC funds.
• Hedge Funds - Like traditional VC funds, hedge funds are generally the preserve of wealthy individuals, institutional investors and pension funds, and are considered more risky investments. In recent years a number of mutual fund companies have launched "hedge-fund-like" products, which allow the average investor to participate in this asset class. These include offerings such as the Montgomery Global Long-Short Fund.

  Unlike regular mutual funds, the use of derivatives means that performance of these funds is measured against a target rather than a benchmark index of similar stocks. In view of this, hedge fund managers claim that returns are less correlated with stock market performance. But unlike VC funds, however, hedge funds invest in publicly traded stocks and derivatives, and so the degree to which returns are uncorrelated with market returns is less than that of a traditional VC fund. And holdings may still overlap with the less risky investments in your investment portfolio, diluting the benefits of diversification.

These comparisons suggest that, alongside investments such as emerging markets funds, venture capital exposure might be considered one of the more valuable diversification tools in the riskier part of an investment portfolio, particularly if an investor's portfolio is heavily concentrated in U.S. equities. This factor is already well recognized by pension funds - that, incidentally, invest many average investors' retirement savings - and institutional investors.

In summary
It is difficult to time the market and because of this, if an investor's portfolio is too concentrated in any one sector, he/she may miss the next great opportunity. An exposure to many sectors ensures maximum benefit over time. Diversification also acts as an insurance policy. A well-diversified portfolio is better able to withstand the vagaries of the markets and helps to smooth investors' returns through good times and bad.

The main attraction of venture capital exposure within a well-diversified portfolio is that venture capital fund returns have a low correlation with those of the equity markets. Although such exposure is not for the faint hearted and should be confined to the riskiest portion of an investor's portfolio, the benefits of this lack of correlation, combined with the potential for higher than average returns, have long been recognized by accredited investors. These obvious attractions have underpinned the rapid growth in the venture capital industry over the past decade.

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This article does not constitute financial advise, it is for informational purposes only. For more detailed investment information we suggest that you consult your investment advisor.