The Nobel Prize-winning economist Harry Markowitz famously once said: ‘Diversification is the only free lunch in finance.’ This bears all the hallmarks of a great soundbite: it’s snappy, uses moderate alliteration and is wonderfully vague about how exactly you’re meant to put it into practice.

All investors know that to mitigate risk, one must diversify. It’s the old ‘eggs in one basket’ maxim. A broad portfolio of investments spanning different stages, levels of liquidity, sectors, sizes and types has a reduced chance of containing highly correlated investments, where macro factors such as housing market changes, unemployment or general market performance can affect all investments in one fell swoop.

By building a portfolio of uncorrelated investments across multiple sectors, you reduce your chances of a single sector experiencing a negative change and it bringing down your entire portfolio; think, for example, of how a shift in oil prices can affect a vast number of investments within that sector.

The tortoise and the hare

On top of this, a varied portfolio allows you to create a balance of risk and return that reflects your overall investment risk profile. Your portfolio will likely range from fairly reliable investments that return a small but steady amount over a longer period of time, such as a Certificate of Deposit, to those that have a comparatively lower chance of cashing in, but if they do they are more likely to win big – like early-stage equities.

Master of none

Diversifying by buying a smaller stake in a greater 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 diversification is not a good isolated investment strategy; you need to also make sure the underlying investments are of the highest possible quality.

But, investing in private companies is difficult. With such a huge amount of choice on offer, really ‘knowing’ 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? Just as Aristotle, Confucius and Socrates all believed, real knowledge is knowing the extent of one’s ignorance; it is vital to see your limits and invest accordingly.

As far as we can tell, this can be achieved through one of two ways:

  • Train to become a proficient investor in one or two sectors and select the deals you think will do well
  • Follow professional investors experienced in varied sectors and invest alongside them

Follow the leader

This is exactly what we do; if you’re still unsure what we mean by ‘investor-led model’, this is literally it. By having a professional investors (angels, funds, VCs) negotiate the terms for and lead every round, we give you the chance to discover what they see in that opportunity.

Since lead investors come from all sorts of background and specialise in different areas, SyndicateRoom is able to work with companies from all sectors, choosing investment opportunities to list based on their quality, not their industry, and allowing our investor base to decide whether or not these opportunities fund by investing directly.

At the end of 2016, SyndicateRoom’s portfolio featured businesses from the life sciences, property, biotech, education, financial services, hardware and IoT, security, marketplaces and ecommerce, media and lifestyle, enterprise software, and environment and logistics.

This is all well and good if you have the time and inclination to work through individual opportunities, conduct careful due diligence and decide where to put your money. 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.

Size matters

Funds allow you to access 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 by virtue of being transparent, offering significant diversification and charging low fees – something previously reserved for the very wealthy but now accessible to near all. 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 and a passive product, and leaving them to do their thing, as the practice of frequent rebalancing can erode returns due to associated fees.

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The Syndicate: Due diligence issue

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Options for passive investors to diversify in the early-stage space are limited. It’s possible to invest in an actively managed EIS fund, but these tend to invest in five to eight opportunities each and generally adhere to a 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.

We found this lack of diversification and low portfolio size very strange. 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, thereby increasing your risk exposure.

It’s this counter-intuitive behaviour that drove us to build the first passive EIS fund: Fund Twenty8™.

The first passive EIS fund

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 alongside which Fund Twenty8™ invests, benefiting from their knowledge and experience.

This is how Fund Twenty8 works. First, opportunities are sourced from successful raises on the SyndicateRoom platform. The fund then tracks investor appetite and automatically invests alongside members on a proportional basis until the company’s funding target is met. If an investment is oversubscribed and goes into overfunding, the fund invests more, securing a larger weighting. To get an idea of the businesses that have recently funded through SyndicateRoom, see our portfolio page.

I’ve been an SR member for over three years and have been impressed by their professionalism and the consistently high quality of opportunities. I’d been investing in individual companies, but was really attracted by the additional diversification element Fund Twenty8 offers. I think it being a passive fund that uses investor appetite to determine fund deployment is a very good idea, as it diminishes the risks associated with an individual fund manager.

Alistair Gray

SyndicateRoom member

I’ve been an SR member for over three years and have been impressed by their professionalism and the consistently high quality of opportunities. I’d been investing in individual companies, but was really attracted by the additional diversification element Fund Twenty8 offers. I think it being a passive fund that uses investor appetite to determine fund deployment is a very good idea, as it diminishes the risks associated with an individual fund manager.

Fund Twenty8 was developed and named based on industry research into early-stage investment performance. NESTA’s Siding with the Angels report found that angel investors had selected investments that achieved a likelihood of ~10% of returning 10x the initial investment. Using these statistics, the Intelligent Partnership EIS Industry Report 2014 calculated that a portfolio would require approximately 28 investments to have a 95% confidence level of securing at least one investment returning 10x the initial investment.

Empirical data

To see how these inferences could apply to the types of opportunities that appear on SyndicateRoom, we looked at our historical portfolio. Given that we launched in late 2013 and were planning to launch the fund in 2016, there wasn’t a great deal of data to go off, but what we did see certainly looked promising.

I’ve been a member of SyndicateRoom for about a year and wanted to get exposure to early-stage equities, but was unsure how to go about diversifying my investments and which companies to choose. I invested in Fund Twenty8 because it allows me to invest in these EIS-qualifying opportunities while spreading the risk across lots of companies.

Emma Collins

SyndicateRoom member

SyndicateRoom investors have invested in 68 EIS companies since 2013, altogether spanning nine sectors. Using historical investment data, we are able to show what the fund would have looked like if it had been deployed over 2015. We are then able, using subsequent equity events, to value the investments as of July 2016. The fund was valued as of July 2016 to be worth 163% of subscriptions; after fees and including EIS tax relief, this gives a value of 220%. NOTE: It should be noted that past performance is not an indicator of future returns.

While it should be noted that the exact composition of the simulated portfolio should not be used to make any investment decisions with regard to the Fund, it does demonstrate its potential for diversification.

Fund Twenty8™ closed for the first time in April 2017, raising a total of £4.5m, outstripping its initial target of £3m; 233 people invested into the fund. It has since begun deploying, the existing and pending investments already spanning six sectors.

Suffice it to say, lunch is on us.

If you want to learn more about the fund or be notified when the next fund opens later this year, visit www.syndicateroom.com/fund-twenty8.