De-Risking Risk Capital: A Lightweight Angel Fund

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This discussion springs from Boris Mann‘s post today, which touches on the need for “fail money” in Canada.  I agree with nearly everything he says, and it can’t be disputed that more active capital is required to continue the growth of the startup economy in Canada and build our web and digital media industries.

My reaction though is centred around (1) I hate the term “fail money”, but I know what he means is that we need more capital going to companies to TRY, and half will fail, which needs a high risk tolerance and (2) I’m a small-time angel investor myself, and at my level this concept makes me very nervous as an investor.

The issue is that I’m not investing enough to create a portfolio effect to counteract the high risk of any single investment.  I know others in the same boat, people with tens of thousands to spend, which only enables 1-3 investments, which gives you a really high risk.  We need a mutual fund of angel investing.  While startup accelerators and angel funds or super-angels come close to this, it’s not working well in Canada right now.

I talk about this quite a lot in my MBA thesis, which is a startup accelerator business plan (posted on this blog earlier today).

What I’d like to create is an investment vehicle that is very public about the status of its fundraising rounds, through an investor portal.  Any investor with at least $5,000 to spend can create an account, see the status of any rounds being raised by the fund or its portfolio companies, become accredited, and commit funds to any of the rounds.

The benefits of a very open, public, and broad approach include:

  • Creating a valuable contact database of interested potential investors
  • Remove barriers to participation for small investors
  • Significantly de-risk startup investing by allowing portfolio approach
  • Remove fundraising risk by casting a wide net
  • Open approach will generate significant attention and interest
  • Open and frequent communication keeps investors and prospects engaged with our companies and efforts
  • Open and requent communication also increases investor satisfaction, leading to high rates of initial and repeat investment
  • Ability to offer rounds being raised by portfolio companies and other unrelated startups to this investor portfolio, perhaps in return for fee or equity

This structure is a modification of the currently popular super-angel approach, and would obviously require one or two active investing partners to be doing the legwork.  The innovations here are around the broad community of investors and the unusual level of openness and transparency.

From my business plan, here’s a mockup of how I imagine the investor portal looking:

Better Personal Investing

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“The index fund is a good innovation, not because it has any magic – anone can figure it out – but simply because by owning the market at a very low cost you will, by definition, do better than everyone who owns the market at a very high cost” – John Bogle

I think by now we’ve all heard some stats on the poor long-term performance of actively managed funds.  From mid-2004 to mid-2009:

  • S&P 500 outperformed 63% of managed large-cap funds
  • S&P Mid-Cap 400 outperformed 73.5% of managed mid-cap funds
  • S&P Small-Cap 600 outperformed 67.7% of managed small-cap funds

Of course anomalies exist!  I’ve seen hedge fund prospectuses (prospecti?) with years that enjoyed gains in the hundreds of percents.  On a more reasonable basis, we see active funds that will outperform the market for five years at a time.  But this doesn’t mean that they have any “secret sauce” or expert opinion that can be applied consistently to win.  In fact, since there must be thousands of managed funds right now in North America, and tens if not hundreds of thousands of asset managers, there’s no way that any of them are able to consistently beat the others.

And you never know which fund will be outperforming in which year.

You need to avoid two things:

1) Wasting your time trying to identify mutual funds that will do well – the research and uncertainty involved is annoying and most people are unqualified (myself included)

2) Decreasing your returns by paying significant management fees.  The funds that my bank account manager recommend all have expense ratios between 1.4% and 2.25% annually.  That comes right off the top of your returns.  This sounds small but has a big effect: If we invested $100k for 20 years, 5% will result in $265k, and 7% will result in $386k.  That’s a big difference.

How do we avoid these?  Follow the warning in the quote at the top – try to match the market at the lowest possible cost.  We do that with ETFs, which have expense ratios more like 0.25%.  You just boosted your returns by over 1% annually compounded.  That’s huge.

I love the Couch Potato Portfolio.  Individuals can follow it with minimal investment knowledge and minimal time investment and produce market-tracking returns that will beat most managed funds over any time period over say five years. (Intro here, but most of it is covered in this post).

You buy a group of only 3-5 ETF funds in your cheap discount brokerage account, and you rebalance twice a year.  Rebalancing is when you sell the ones that have gone up and buy the ones that have gone down, so they go back to being evenly distributed.  This GUARANTEES that you are buying low and selling high :)

Here’s an example, using $100k in the “High-Growth Couch Potato”, which I use since I’m young-ish and can have a higher exposure to stocks.  There are a few options on the Canadian Business site for ways to tailor the program to your investing style / goals: Meet the Potato Family.

Initially, I buy:

  • 25% Canadian Equity (iShares XIC, MER 0.25%)
  • 25% US Equity (iShares XSP, MER 0.24%)
  • 25% International Equity (iShares XIN, MER 0.5%)
  • 25% Canadian Bonds (iShares XBB, MER 0.30%)

Your total expense ratio is 0.32%, compared to the 1.5-2% for managed funds.

Spend an hour or two every six months rebalancing.  Say our Canadian and US Equity funds have gone up and the rest are flat or down, I sell those two to bring them to 25% of the new total value and spread the proceeds to the other three in amounts that bring them up to 25% as well.

Read more about the process at the Canadian Business website, which goes into detail on the rationale, the process and the variations:

Introduction

Do the Couch Potato: Step by step guide

Building blocks: ETF suggestions