INVESTOR EDUCATION

Why should I include ‘early stage securities’ in my investment portfolio?

Traditional versus alternative investments

For retail investors, the options when deciding where to invest have typically been the traditional asset classes of cash, fixed-interest, equity (shares) and property.

These ‘traditional’ asset classes are either accessible directly, as in buying them straight-out in the investor’s own name, like shares; or indirectly through managed funds, which pool investors’ money and the investors own a number of units proportional to their invested amount.

The asset classes

An asset class is a category of investment. The major asset classes are:

Cash

Cash includes money in bank savings accounts and term deposits, as well as investments in bank bills and similar securities. Cash investments provide stable, low-risk income in the form of regular interest payments. Cash is a very defensive asset class, being low-risk in terms of return volatility: but cash earns a low return that is fully taxable, and there is no capital growth.  

Fixed interest

Fixed-interest (or fixed-income) investments include government bonds (issued by the Commonwealth of Australia), semi-government bonds (issued by the state or territory governments) and corporate bonds (issued by companies). In buying bonds you lend money to the government or the company, and it undertakes to pay you the regular interest payments at an agreed interest rate (or coupon) for an agreed period of time, and to return your initial investment at the end of the term.

Commonwealth government bonds are safer than state or territory bonds, which in turn are safer than corporate bonds. But the safety of a bond depends on whether you will be able to hold it to maturity. If at any time you want to sell it on the bond market, because bond prices fluctuate you may incur a capital loss (or gain.)

Bond prices move inversely to interest rates: if the economy is slowing, the Reserve Bank of Australia (RBA) will usually lower interest rates to stimulate borrowing, spending and economic growth. Bond prices usually rise, making bonds a sound defensive asset in a weak economic environment.

The fixed-interest asset class also contains credit investments, which some investors see as an asset class in its own right. ‘Credit’ is associated mostly with corporate credit risk. The term covers corporate investment-grade bonds (those rated BBB- or higher), corporate high-yield bonds, corporate loans – instruments that carry the ‘credit’ risk of the credit quality of the issuing company.

Shares

A share represents part ownership of a company: returns are made up of capital growth as well as income from dividends. Shares are generally bought and sold on a stock exchange. You can choose to invest in Australian shares, global shares or a mix of both. Shares are generally considered a long-term investment, to allow the compounding of retained earnings, with a time frame of five to seven years, but may be traded over holding periods measured in the hours, being generally very easy to buy and sell, in any amount.

Shares are the most volatile of the major asset classes in terms of standard deviation (variability around an average), but over the long term tend to be the best-performing asset class, garnering the equity risk premium, which holds that over the long term, shares will outperform the risk-free rate, which is the return on cash/treasury bills (or commonwealth government bonds.)

Investors demand this premium to invest in the more risky asset of equities, and they generally receive it, although the equity risk premium is not guaranteed over any and all timeframes of sharemarket investment. Moreover, the equity risk premium refers to the market benchmark return, and cannot be relied upon in terms of individually selected stocks or portfolios.

In the Australian context the long-term return of the highest-quality dividend paying stocks is augmented by the tax benefits of franking credits on company dividends, which flow from companies’ Australian-derived income. These generally add more than 1% to the after-tax return from Australian shares for Australian investors.

But in the short term, the sharemarket can be highly volatile, and dramatic falls in share prices (and the market indices) are possible. Between February 2007 and November 2009 the main Australian market, the S&P/ASX 200 Index, lost 52% of its value.

Shares are considered a ‘growth’ asset for long-term wealth creation, with some income from dividends along the way. (In recent years, the income from fully franked dividends rom blue-chip shares like the major banks and Telstra has become a very competitive income source for many investors, particularly self-managed superannuation funds, or SMSFs, which benefit hugely from the tax concessions in the super environment.)  

Australian investors can also easily buy international shares, although this introduces currency risk into the investment proposition. The currency factor can either magnify, lower or wipe out completely any gains on the shares, as well as either worsen, lessen or erase losses on the shares.

Property

Many Australians invest directly in property by buying the house they live in, or a house to rent out for extra income, but it’s also possible to buy commercial buildings such as offices, shops and warehouses directly. Investors can also buy units in a real estate investment trust (REIT) that is listed on the stock exchange, and share in the ownership of very large diversified portfolios of commercial, retail, hotel and industrial property – Australian and international – with the instant liquidity of the stock market.

Direct unlisted property is also available through unlisted property trusts and syndicates, although these are much less liquid than REITs (which for many investors is precisely the attraction). Property is considered a ‘growth’ asset for long-term wealth creation, with some income from rent along the way.

Australian Direct Property Annual Total Returns to 31 December 2013

Period (years) Retail (% a year) Office (% a year) Industrial (% a year) Composite Property (% a year)
20 11 9.6 11.6 10.3

Source: IPD/PCA/Atchison Consultants

Alternative investments

Over the last two decades, the menu of available investments has grown significantly, as exposures created initially for institutional investors have filtered down to the retail arena. A variety of so-called “alternative assets” has emerged, offering investments that show little (or preferably, no) correlation with the mainstream asset classes – particularly the sharemarket.

Low correlation means a return profile that does not move in concert with that of the sharemarket, and shows some independence from it. Investors wanting a well-diversified portfolio do not want all of the components of a portfolio rising or falling in value together – so the low correlation of alternative assets is highly sought.

The move to alternative investments was pioneered late last century by the big US university endowment funds, which manage money on behalf of institutions such as Harvard, Yale and Stanford universities. These funds began to diversify beyond stocks and bonds into investments such as hedge funds, private equity and “real assets” (real estate and managed timberland).

Some of the alternative asset classes are defensive and low-risk, generating relatively stable income streams and showing low volatility – for example, infrastructure – while others are high-risk, high-volatility and potentially high-return, for example, venture capital.

The assets termed ‘alternative’ range across several main kinds:

Infrastructure

Infrastructure covers the huge fixed assets that enable essential services to be provided, such as electric power, gas, water and sewerage; roads, railways, ports, airports and telecommunications installations. The sector can be extended to social infrastructure, including hospitals, schools, parks and sporting facilities. Infrastructure assets generate a long-term cash flow with a high yield and little volatility. They are long-term cash flow generators.

Commodities

In recent years, investors have begun to look to commodities as a way to potentially gain enhanced portfolio diversification, protection against inflation, and equity-like returns. While not quite a fully-fledged separate asset class, commodities investments – usually based on futures market indices, such as the Goldman Sachs Commodity Index and the Dow Jones IAG index – have opened up exposures to different risk factors than the typical risk factors affecting other asset classes, and the potential for uncorrelated returns. Because commodity prices are among the direct drivers of inflation, commodities are often considered one of the few real assets that can protect against rising inflation.

Hedge funds

These are managed funds that can invest across many different markets, with maximum flexibility and unrestricted mandates, so they can make money regardless of what the share and bond markets are doing. The terms ‘hedge fund’ and ‘absolute-return’ fund are virtually interchangeable, because hedge fund managers are not concerned with how the market is performing: they are seeking a positive return, above a market-independent benchmark such as the official cash rate or the inflation rate.

Hedge fund managers back their skill to generate returns independent of the performance of traditional assets, using a wide range of strategies across all kinds of asset classes. The returns from absolute-return funds are often described as “skill-based” returns.

There are at least 14 distinct hedge fund strategies, but the basic strategies include:  

  • Long/short: going long (buying) in under-valued securities and short (selling) in over-valued securities, particularly shares.
  • Market-neutral, a simultaneous long/short strategy that tries to take matching long and short positions in different stocks, to increase the return from making good stock selections, while stripping-out the returns from the movement of the broader stock market.
  • Global macro: investing on the basis of economic and political events, analysis and forecasts.
  • Tactical asset allocation: researching, identifying and exploiting anomalies in different industries, currencies and stock markets, and leveraging into them, using derivatives;
  • Event-driven: taking advantage of market reactions (specifically, over-reactions) to specific situations, for example takeovers, debt defaults, credit downgrades (even natural disasters)

The major perceived attractions of hedge funds are their ability to generate returns in a manner that does not rely on the normal investment cycles, using proprietary trading strategies, and their low correlation to normal market movements. They are considered to smooth out the volatility of a wider portfolio of conventional asset classes, despite being intrinsically volatile themselves.

Art/collectibles

Investment in art and other collectible items such as coins, stamps and wine is occasionally mooted as a non-correlated alternative asset, because the valuation of these assets is not driven by the same factors as the traded investment markets of shares, bonds or property. In theory, art’s lack of correlation with the traditional assets makes it an excellent tool for portfolio diversification. But the problem for non-experts investing in these assets is the subjectivity of valuation, and the potential illiquidity.

Private equity

Investment in private companies that are not listed on a stock exchange is known as ‘private equity,’ or ‘private capital.’ This capital could fund the company’s start-up – in which case it is termed ‘venture capital’ – or it could fund ongoing operations, new product development, strategic expansion or restructuring, in which case it is usually called ‘private equity.’

In theory, venture capital and private equity are on a continuum in terms of the stage of a company’s development when investments are made. Venture capital is often made pre-revenue – as the term suggests, before a company has generated any revenue – while private equity typically seeks to restructure an already profitable (or hitherto profitable, but struggling) company and take it to sale, either in a trade sale or an initial public offering (IPO) on the stock market.

A specialised form of venture capital is ‘early-stage’ venture capital, which is a pre-revenue stage of investment that helps company founders move from an idea to getting their product or service to the market. ‘Early-stage’ equity investment usually funds the company moving to the market, beginning to sell its product or service to its first customers. This funding may also cover product development, initial production (which may involve manufacturing), employment of key staff and initial marketing and branding.

Asset Allocation

Asset allocation is the process of building an investment portfolio using the available asset classes, to achieve a balance of capital growth, income and risk that depends on the investor’s needs, expectations and risk appetite. The asset allocation applies actual percentages to the concept of diversification.

The basis of asset allocation is that different investments (asset classes) have different levels of risk and return: historically, the riskier an asset is, the higher is its average return over time. Risk is usually measured by volatility, or standard deviation, a statistical measure of the dispersion of returns relative to the average: however, after the global financial crisis (GFC) of the late 2000s, risk is also considered in terms of the likelihood of losing money, that is, the extent of the maximum loss of value that can reasonably be expected in an asset class.

Academic research consistently shows that the asset allocation of a portfolio plays a much bigger role in a portfolio’s performance than the individual assets chosen for it – the asset allocation typically accounts for about 90% of portfolio performance on a risk-adjusted basis.

Risk and return

As the potential return of an investment rises, so does the level of risk being run, and so does the level of uncertainty of the outcome. These observed principles give rise to the paradox of risk, which is that an investor can only make the high returns essential to creating wealth by running relatively high risk.

Put another way, an investor could invest their money in cash, and have low risk and a low level of uncertainty about the outcome of the investment – but not create as much wealth as the next investor, who invested in riskier shares. In the context of creating wealth for one’s family and retirement, that in fact becomes an unacceptable risk.

The risk-return profile of each asset class is markedly different. Here are the ten-year risk-return figures for a range of asset classes, as calculated by Morningstar.

 

Australian shares Global shares (hedged) Australian REITs Global REITs

(hedged)

Australian Fixed interest Global Fixed interest (hedged) Cash Infrastructure (hedged) Commodities Hedge Funds
Ten-year return (% a year) 9.6 4.4 2.5 8.4 6.4 7.5 4.9 11.7 1.2 3.8
Ten-year standard deviation (% a year) 13.7 11.6 18.4 21.9 2.7 2.8 0.4 12.6 14.0 11.2
Diversification

Diversification is the process by which a portfolio is spread across different investments, which as the term suggests are diverse, and driven by different factors. The object is twofold: to pick up on different sources of return, to maximise the likelihood of the portfolio increasing in value; and also, to lessen the overall risk of the portfolio by increasing the chance of at least some portion of the portfolio performing well even if the majority of it is down.

Every investment in a portfolio should either be a source of return, or have a diversifying effect, away from the main component of the portfolio, which is usually equities.

Diversification should be put in place both across and within asset classes. Not only should you have a good mix of shares, bonds, property and alternative-asset exposures, each ‘bucket’ of your portfolio should be diversified. Your share investments should be spread across different stocks representing a range of industries, not just mining and banking. Your bond investments should have a range of maturities. Your property holdings should include at least another sector – commercial, retail or industrial – in addition to your residential property exposure. If you have absolute-return equity funds, it’s a good idea to balance these with infrastructure ‘real-asset’ investment.

The other element of diversification that works well for Australian investors is investment outside Australia. For example, in shares, global investment can give your portfolio an interest in sectors that the Australian market does not have – for example, information technology, global industrials, global pharmaceuticals and telecommunications.

Overseas investment exposes the investor to currency risk, but even this can be viewed as another layer of diversification: giving the portfolio exposure to currencies other than the Australian dollar

Correlation

Diversification works because of correlation, which measures the degree to which investments or asset classes tend to rise or fall in value together. If two investments have a correlation of 1, they are perfectly correlated and always move in the same direction. Conversely, two investments with a correlation of zero always move in opposite directions.

Most Australian investment portfolios have their heaviest investment weighting in shares, Australian and global. Ideally, those investors want a counter-balance in their portfolio of an investment holding that is not correlated with shares and will not fall when shares do.

Typically, the simplest correlation strategy is to combine bonds with shares, because bonds show a negative correlation with shares. But adding different asset classes to the portfolio brings different correlations into play: a portfolio should be constructed to tap into a range of return sources, with several components showing low correlation to the traded markets of shares and bonds, to smoothe out the long-term return profile.  

Role of early stage securities

Early-stage securities has benefits as a low-correlation portfolio diversifier – the earlier the stage is the investment made, the more benefits the investment adds in terms of correlation (but with correspondingly higher risk.) While early-stage securities is also an equity investment, it is made at a different stage to private equity (and listed shares) and can be uncorrelated to these for long periods of time. Correlation can be considered to be enhanced because an early-stage investment is not liquid until an exit, which may take several years.

The benefits of having early-stage securities in a diversified investment portfolio is as a source of return – because the expected return on a successful exit is very high. A November 2007 study published by the US-based Kauffman Foundation, titled Returns to Angel Investors in Groups, found the average return of US ‘angel’ (early-stage or venture capital) investments since 1987 was 2.6 times the investment in 3.5 years, or approximately 27% Internal Rate of Return (IRR).

However, the risk of such investments was also clearly indicated by the Kaufman study, which found that 52% of all of the investment ‘exits’ returned less than the capital the angel had invested in the venture, while 7% of the exits achieved returns of more than ten times the money invested. This 7% of exits accounted for 75% of the total investment dollar returns. Early-stage investors thus should expect that half of the portfolio will fail, and less than 10% of exits will generate more than 75% of the total return. Thus, portfolio size, diversification and thorough due-diligence on investment candidates are critical for in a portfolio of early-stage investments, so as to capture the successful investment returns.

Key message

Early-stage securities offer the opportunity for higher-than-average returns. A properly diversified investment portfolio includes a 5-10% allocation in alternatives, and this component could well include early-stage securities. Risks can be managed if a sound risk mitigation strategy is in place.

Due diligence – how to choose?
Making an investment via VentureCrowd.
What are early stage securities?