Portfolio Construction & Performance for New Investors: An Interview with Abdulaziz Hayat

The global market is now on the upswing; worldwide vaccination drives have brought businesses back from the seemingly never-ending pandemic slump. Amid this, global investments are picking up again, and experts like Abdulaziz Hayat, a Harvard University Finance alumnus, are guiding investors to build their venture capital portfolios effectively.

Abdulaziz shares how the typical performance and behaviour of early-stage VC funds may shock finance amateurs. He elaborates how it is normal to lose around 20 to 30 percent of seed investments, including total loss of capital. Yet, even after such occurrences, it is entirely possible for a fund to return 3-4x its capital and allow fund managers to raise their next fund.

Adding to it, Hayat mentions two concepts that are commonly referenced when analyzing the performance of an early stage fund: the J-Curve and the Pareto Principle.

Returns from the investments of any portfolio tend to follow a power law: the best performer returns better than all other investments combined. The second-best performer returns better than everything except the best performer, and it continues. This Pareto principle implies that the top 20 percent of a portfolio's assets account for 80 percent of all the returns of the fund.

On the other hand, the J-Curve demonstrates another pivotal highlight; almost all the returns of a fund are derived from the long-term growth of the best performers.

Hayat extends, "Early in the history of the fund, performance does not vary in the extreme and Net Asset Value (NAV) of the fund can dip below the fund's Asset Under Management (AUM). This is because a few investments tend to fail fast in the immediate term. The internal rate of return (IRR) of the fund goes negative at first before strongly breaking to the upside as the good bets begin to perform well in the long run.”

Nevertheless, for those unfamiliar with venture investments, wide variance in performance and returns can be a reason to avoid the asset class. However, as Aziz explains, venture capital fright can be kept at bay with patience and indexing.

"It requires patience for high risk to become high reward," he puts forth.

For low-risk investors, he advises investing in a fund rather than directly. It helps reduce risk and targets a return of 3-4x the invested capital in a period of five or so years. Hence, Aziz recommends different strategies to investors who are risk-averse and unable or unwilling to make direct investments. Hayat explains it by navigating through the argument that the probability of any one investment performing well is not high. It is not uncommon to lose most of your capital in any one bad investment, however the potential upside from a winner within a portfolio is theoretically infinite.

Hayat claims cost averaging is also one of the most critical aspects of portfolio construction, and this is true to a degree in venture capital. It reduces the probability of missing out on investing in a portfolio winner on account of adverse market conditions. Apart from this, sticking to one stage of investments, setting up a clear thesis, and possessing a thorough understanding of the Pareto principle and the J-Curve implications are some of the other vital components of sound portfolio construction.

It is also one of the most integral pieces of advice Aziz imparts to companies and family offices setting up their venture wings for the first time: create an investment thesis and stick with it! He always endeavours to make businesses and organisations comprehend that they need to avoid suspending their investment operations because of short-term adverse events in the market.

Interestingly, when questioned whether it is the right time to invest, Hayat responded, backed with his entrepreneurial instincts, that it is always a good time to invest and that consistently investing across time and geography is key.

"Poor investors stop investing and panic sell; great investors keep investing and hold through rough times," Hayat remarks on the typical investor behaviour he encounters frequently. However, something goes beyond this. He underscores that excellent investors maintain the same pace of investment during both good and bad macroeconomic scenarios. Investors unaccustomed to this asset class may see the concentration of fund profits in one or two deals as a failure when, in reality, it is only the expected performance of an excellent investor.