Sharpe ratio is a way of quantifying returns based on risk, specifically it is the average return earned in excess of the risk-free rate per unit of volatility or total risk.There are some limitations, for instance slightly different distributions of returns for a portfolio give quite different Sharpe ratios. But overall it’s a widely accepted metric. Over the past 25 years, the average annual Sharpe ratio for the S&P 500 has been 1 and it is often taken as the baseline for judging different asset classes. Anything lower than 1 is considered a bad investment since you could just put the money passively into S&P 500 and do better.
So where does VC stack? The short and widely publicized answer — not well. As an example, here is an example from John Kinlay, a well-respected quant. Kinlay took data from Cambridge Associates on quarterly pooled end-to-end net returns to LPs from 1981 to Q2 2014 and found the Sharpe ratio to be 0.68. If you change the boundaries a bit you can get a higher number but bottomline, VC as a category is essentially under 1.
The top 10% of VC funds perform far better, with Sharpe ratios higher than 3, but you can never know for sure what that upper decile is before the fact. There are three main reasons venture capital overall still makes sense.
One, they are relatively uncorrelated to other asset classes. In this same time period the correlation of VC and S&P averaged only 0.34. As the first column of the graph below shows, that puts VC between Utilities and Oil, with potentially much higher prospect of returns. Furthermore, as the events of the last few weeks have shown, in downturns such as the present one almost most correlations go to 1 (ie to the stock market) over the short run. Meanwhile the value of a VC portfolio changes slower and the liquidity tightening gives VCs more leverage and access to better terms.
Of course there are other ways of creating a diversified portfolio that minimizes risk-return. But VC is a powerful way of doing so which is why LPs typically invest 1-10% of their assets in this class.
A second reason is that VC allows for outsize returns. Very few types of investment can even realistically get a 100x or even 10x in the same horizon as venture capital. And for those deals, a savvy GP (ie the VC) can drive even higher returns by continuing to invest more which means a LP (ie the VC’s investor) can put more capital to work.
A third reason is impact in all its dimensions ie economic, political and social. The diagram below summarizes key findings of a paper by two Stanford scholars from 2015.
If you are looking to shape the economy, potentially partner or acquire companies for your own day job, learn new ideas, network with good people, or provide mentorship — VC is arguably the most exciting way to do so.
Written in collaboration with Eugeniu Plamadeala and originally published on “Data Driven Investor,” am happy to syndicate on other platforms. I am the Managing Partner and Cofounder of Tau Ventures with 20 years in Silicon Valley across corporates, own startup, and VC funds. These are purposely short articles focused on practical insights (I call it gl;dr — good length; did read). Many of my writings are at https://www.linkedin.com/in/amgarg/detail/recent-activity/posts and I would be stoked if they get people interested enough in a topic to explore in further depth. If this article had useful insights for you comment away and/or give a like on the article and on the Tau Ventures’ LinkedIn page, with due thanks for supporting our work. All opinions expressed here are my own.