An Interesting Paradox: Comparing the investment risk of an SEIS portfolio with a FTSE 100 Tracker
“The real trouble with this world of ours is not that it is an unreasonable world, nor even that it is a reasonable one. The commonest kind of trouble is that it is nearly reasonable, but not quite. Life is not an illogicality; yet it is a trap for logicians. It looks just a little more mathematical and regular than it is; its exactitude is obvious, but its inexactitude is hidden; its wildness lies in wait.”
Peter L. Bernstein, author of Against the Gods: The Remarkable Story of Risk
The title of this article is about as counterintuitive as one can get for an equity investor. On the face of it, and quite rightly, a single Seed Enterprise Investment Scheme (SEIS) investment is at the extreme end of the risk spectrum. Given that SEIS qualifying companies have been trading for less than a couple of years, and accepting that many are likely to fail and/or end up in bankruptcy, it seems churlish to suggest that this asset class might be able to outperform Britain’s blue chip leaders.
Yet, although an SEIS investment centred on one company is definitely high-risk, one can plausibly argue that a portfolio of SEIS investments might actually have a lower Total Return downside and a greater upside than the FTSE 100 Index due to (a) the combination of the binary nature of SEIS returns combined with (b) the generous tax reliefs on offer from HMRC. Let’s examine these two investment drivers in greater detail.
The reliefs available
First let’s look at the generosity of the reliefs. SEIS tax reliefs on offer from the UK government are indisputably attractive. Relief is available at 50% of the cost of the shares, on a maximum annual investment of £100,000. A further 14% is available from capital gains reinvestment relief. Combined, this means that an investor can potentially be on risk for only 36 pence on the pound invested. However, of crucial importance for investors is Loss Relief, whereby investment losses can be further offset against either Income Tax or Capital Gains Tax. For a 45% marginal tax payer, this percentage of that loss can be used against the investor’s risk capital to reduce the taxable income for the year in which the shares were disposed. In sum, certain eligible investors may find that on a £1,000 investment, they receive £500 back in the form of Income Tax Relief, £140 in CGT reinvestment relief and a further £225 back in loss relief, meaning that they would ultimately have only lost £135 on the investment. Loss relief is crucial for overall portfolio returns given that SEIS company returns tend to be binary. Last but not least from an investor’s perspective is that successful SEIS investments receive all their gains free of tax, as long as they are kept for three years before disposal, whereas investors directly into FTSE 100 companies will have both a dividend income tax, and capital gain tax liability.
The binary nature of SEIS returns
An examination of the binary essence of SEIS investing is important because it stands in stark contrast to the FTSE 100 as a whole as well as its individual constituents. It is also important in that it crucially highlights the necessity of taking a portfolio approach to SEIS investing. The reason why individual growth company returns are usually binary is fairly obvious: a young, growth company either matures into a moderate or high-return success or it fails completely and usually in short order. In fact, for the SEIS portfolio investor, it is the non-binary returns that are most problematic because they could be left with a company that neither grows nor fails, is not successful enough to have an ‘exit’ of any kind, and is almost completely illiquid. Much better to have the company fail, take advantage of Loss Relief and get on with the prickly job of finding winning growth companies.
The essence of this article can best be captured by using some worked examples to illustrate what is otherwise a rather counterintuitive thesis. A good SEIS fund manager should be able to regularly, if not intermittently, source individual SEIS investee companies that could provide 5x, 10x, and 15x returns. Very lucky managers may unearth the odd stock that returns over 100 times the original investment, particularly in the technology sector. However, any realistic investor knows that there are going to be failures. This is fine for the SEIS portfolio manager as long as there are some decent successes.
To illustrate this point, consider a portfolio, equally spread across five SEIS qualifying investments that after five years is liquidated. The portfolio consists of four complete failures (i.e. loss of 100% of the gross investment) and one successful exit with a 2x return (which is rather modest by growth company standards). If such a return scenario were to be replicated amongst five FTSE 100 companies, the results would be calamitous and would probably mean that Britain was in the grip of an unrelenting depression. Even during the dark days of 2008, the FTSE 100 lost just under 30% for the year. However, the aforementioned SEIS portfolio would have returned 16% of the net investment for an investor who did not claim CGT reinvestment relief, and a 61% return on the net investment for an investor who did claim CGT reinvestment relief. In plain English, an investor who originally invested £100,000 in this SEIS portfolio of 5 companies, would have almost immediately received £50,000 back from HMRC (or £64,000 for CGT relevant cases) and liquidated the portfolio, receiving an additional £58,000 with no capital gains tax to pay on disposal.
If we slightly relax the assumptions under Example 1, we might be surprised by the return profile. If the same five SEIS qualifying investments were selected and the modestly successful 2x return becomes a 5x return, whilst the others four fail, our investment returns look quite different. This SEIS portfolio would have returned 136% of the net investment for an investor who did not claim CGT reinvestment relief, and a 228% return of the net investment for an investor who did claim CGT reinvestment relief. In plain English, an investor who originally invested £100,000 in an SEIS portfolio of five companies, would have almost immediately received £50,000 back from HMRC (or £64,000 for CGT relevant cases) and liquidated the portfolio, receiving an additional of £118,000 with no capital gains tax to pay on disposal.
The two examples above clearly illustrate how the combination of Loss Relief, Income Tax Relief, and CGT disposal relief contribute to illustrating the counterintuitive nature of the argument. In Example 2, the post-tax returns would be the envy of any hedge fund manager, and yet an 80% failure rate sounds like a recipe for disaster. If I were to provide a returns analysis of what a decent SEIS fund manager should achieve (e.g. one 10x, one 5x, one 2x and two failures), the post-tax returns begin to look silly.
How do FTSE 100 returns compare to the returns we have just outlined? The ten year average annual total return for the FTSE 100 until the end of 2014 was 8.14% in nominal terms, which equates to an average real annual return of 5.42% when deflated by the CPI. If we consider that a typical holding period for an SEIS portfolio is 5 years, the equivalent real 5 year cumulative return for the FTSE 100 on a £100,000 investment would be 30.2%, meaning that an investor would receive £130,200 on a pre-tax basis. Whilst this compares favourably with our portfolio in Example 1, it pales in comparison to the portfolio in Example 2. Given that even the second example is not exactly what one would consider to be a superlative performance, what this really illustrates is that employing a solid SEIS fund manager should allow the investor to make gains far in excess of what the FTSE 100 will offer going forth.
The paradox highlighted in this article fits nicely into what is known as the fallacy of composition, namely that what is true of the parts must be true of the whole. One of the best-known examples of this involves a member of the audience at the theatre who decides to stand up to get a better view. A strict ‘fallacist’ would argue that therefore, if everyone stands up in their seats, they will all get a better view! Perhaps a more pertinent or notable example of the fallacy of composition in financial economics is the paradox of thrift, which is a central tenet of the writings of John Maynard Keynes. The Keynesian paradox states that when individuals collectively try to save more during an economic recession, then aggregate demand and therefore income and output, will fall and will ultimately result in a lower saving rate in the economy.
At the end of the day, the performance of an SEIS portfolio will exceed that of the FTSE 100 if the SEIS manager invests in at least some modest winners, but performance will be spectacular if the manager invests in a few success stories. It is for this reason that the technology sector is the most popular single sector in SEIS investing. An M&A transaction in the USA that was announced last Friday aptly summarizes the potential to generate significant value in a relatively short period of time in the technology sector. A US technology corporation, Splunk Inc., perhaps the leading platform for real-time operational intelligence, acquired Caspida Inc. for $190 million in a mixed cash-and-share offer. Caspida is positioned in a very vibrant part of the technology sector, providing behavioural analytics for enterprise security. However, this is an extraordinary price for a company that has still to launch a proper product range and is approximately one year old! Furthermore, and in stark contrast to many “old economy” M&A transactions, the announcement provided a boost in confidence to Splunk, leading to its shares closing up over 4% last Friday.
In sum, this article does not suggest that every SEIS portfolio manager has a Caspida-like investment that is just waiting to provide out-sized performance for investors. Yet these sorts of returns are possible and the search for them and the associated risk to the portfolio is significantly reduced by the generous tax reliefs we are offered in the UK. Of course, SEIS is not for everyone. But many suitable investors who understandably caution about the associated risk of a single SEIS investment, may consequently ignore the prospect and positive impact of a portfolio approach, thus ignoring the SEIS sector altogether. This is a mistake as I hope this article highlights. In addition to the possibility of very attractive returns, an SEIS portfolio also has the potential to provide uncorrelated returns with the rest of an investor’s portfolio. Moreover, in light of the changes to investing in personal pensions over the past few years in the UK, an SEIS portfolio should be seen as an integral part of one’s tax efficient investing strategy.