The relative non-risk of startups

Based on recent events I suspect an investment axiom might exist that says: The further an investor is abstracted away from the underlying asset they’re investing in, the greater the risk.

This has been shown recently to be true with Mortgage backed securities, credit default swaps, the black box that is the hedge fund industry and even sovereign debt may qualify.

When you are shielded from your investment by layers of structure, marketing, repackaging and sales teams, you are too far away to hear the alarm bells when they’re ringing.

That got me thinking about the relative risk of being an angel investor in young companies. Angel investors meet with the founders, use the product and in many cases craft the investment terms themselves. Spending a few weeks negotiating a deal with an entrepreneur is itself a revealing process. The investor is exposed to a mountain of data on the underlying asset they’re investing in.

The recent excellent Bloomberg article on the under performance of commodity ETF’s brought this difference home for me. Suited and booted bankers sell commodity ETF’s daily with a prospectus that tells you you’re investing in gold or oil or copper. The impression created is that you’re investing in the underlying asset when in fact you’re investing in a fund that is trading monthly futures contracts for the commodity. Two years later you’re left wondering why your investment has lost 20% while the underlying commodity has gained.

The complexity of financial products and the distance between the average investor and the underlying assets they’re investing in has, I believe, peaked. As the financial crisis that was started in 2008 continues to play out, during next decade I strongly suspect there will be a return to less complexity and a desire to know, touch and meet with the assets that underlie each investment.

While the likelihood of failure in young businesses is high, as an angel investor you know exactly what you’re getting and you have the ability to influence the performance of your asset. Try finding that on Wall Street.