Lack of transparency makes choice difficult
This isn't just the season for last minute RRSP contributions. It's also the peak time of year for labour sponsored investment funds (LSIFs) to raise money for investment purposes. Recall from previous articles (LSIF Risks and Upside of LSIFs) that these funds are quite unlike the plain vanilla mutual funds to which most are accustomed.
A look back
2002 saw a continuation of a trend that began a year ago. Valuations continued to come down and exit windows are now more firmly shut than before. (Recall that venture capital managers can only realize the big potential of their investments by exiting via an initial public offering - an IPO - or by selling to a larger, publicly traded company in the same industry.)
North American venture capital funding has fallen more than 60 per cent from its peak in 2000 while exit activity made a crash landing. In the U.S., venture-backed acquisition activity fell 70 per cent from a year ago while IPOs remained rather flat (but more volatile) compared to their super-low levels of 2001.
Looking further back, LSIFs have performed rather poorly. Over the last five years (ending December 31, 2002), the median LSIF posted a return of exactly zero. Only two of the sixteen funds in existence over that period generated returns in excess of 5 per cent per year. That's not exactly going to inspire investors to do the happy dance - particularly in light of the fact that LSIFs entail significant risks.
The time is right
This may prove to be a good time to invest in venture capital as the private equity markets have suffered just as much as the public markets as a result of the tech bust. However, LSIFs simply didn't buy the amount of junk that regular technology funds did and cash-heavy LSIFs are in an ideal position to pick up quality businesses at what some managers are calling the best valuations since the mid-1990s.
The numbers bear out this claim. I looked at rates of return for the group of LSIFs compared to the Nasdaq 100 index - a technology heavy index - for three key periods.
+ From the end of September 1998 through March 2000 (the tech boom), LSIFs rose in value by 53 per cent while the Nasdaq soared more than 211 per cent.
+ From the end of March 2000 through the end of 2002 (the tech bust), those same LSIFs slumped 31 per cent while the Nasdaq was crushed to the tune of a 76 per cent loss.
Overall, this period saw LSIFs lose a total of 1 per cent while the Nasdaq shed nearly a quarter of its value.
My point: LSIFs didn't experience a 76 per cent loss because they simply didn't experience near the same amount of upside when the tech frenzy was at its peak. However, they have suffered substantially and the closing of key exit avenues has resulted in compelling valuations for venture capital managers investing money today. Hence, the better LSIFs - particularly those that are carrying lots of cash - are in an ideal position.
Tricky performance comparisons
Choosing the right LSIF will not be found via superficial performance comparisons. Due to the evolution of a venture capital portfolio, only funds of similar ages can be compared.
Think of a new LSIF as something like the athletic ability of a twelve-year old child. It shows potential at this young age, but full potential will only known after full development is complete.
Comparing the athletic ability of a twelve-year-old to that of a twenty-five-year-old makes for a meaningless comparison. Why? Because a young person with lots of growth and development ahead is being compared to a person whose physical development has likely peaked.
The same can be said of venture investing, since it can require a full ten years (or more) to realize the full potential from the time of initial investment. Comparing, for example, a three-year-old LSIF to a competing eight-year-old fund will yield no meaningful insight, in my opinion.
Further exacerbating the age-related problems of LSIF performance comparisons are the diverse mandates and constraints characteristic of the funds in this class. Some invest only in particular sectors while others are limited to investing in certain provinces.
Caveat and recommendations
The lack of transparency remains troublesome in the LSIF class of funds. The lack of full and clear disclosure makes it impossible to objectively verify that LSIFs practice what they preach. However, I continue my efforts to weed through the category even though I don't have the ability to perform the depth of research I'd like on these funds. Reason: I know that they draw significant amounts of money during RRSP season.
Finally, make sure to invest no more than 5 to 7 percent of your total portfolio in these risky funds. Then again, if you're simply uncomfortable with LSIFs, you also have a choice not to invest in any of them.
With all that in mind, the following is my list of recommended funds in order of preference:
Working Opportunity Fund, Working Ventures Canadian Fund, Dynamic Venture Opportunities, Ensis Growth, Vengrowth II, and First Ontario.
Honourable mentions are funds which have many positive aspects but that are generally too small for me to feel comfortable recommending them. Two funds fall into this category this year: B.E.S.T. and Lawrence Enterprise.
Next week: my take on the newest breed of LSIFs - those with capital guarantees.
Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at firstname.lastname@example.org
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