Why the index approach to venture makes perfect sense (especially at pre-seed)

Taking the index approach to venture investing makes absolute sense to us Techstars , and lately appears to be gaining wider traction.

A blog post from Patrick Ryan , published on October 2nd, made the case very clearly that when it comes to early stage investing in particular, scale matters.?

Referencing an article from Steve Crossan, Ryan states:??"If you have a 300 deal portfolio instead of a 30 deal portfolio, your chance of tripling or quintupling your money is ~80% higher [...] Perhaps more surprisingly, your chance of 10xing your money doesn’t decrease. The upside of a true outlier outweighs the downside risk of losing money on all the others."

Not only do I think this analysis is spot on, but the Techstars accelerator model is predicated on it. Our $150M Techstars Accelerator 2021 fund (TSA 2021), for example, will invest in 700+ companies. So why does our model of scale + hyper-diversification work for pre-seed??

The traditional venture industry is built on scarcity, and the idea that – thanks to their expertise, insights, and network – VCs are uniquely able to sift through thousands of also-rans to unearth the outliers (https://www.cbinsights.com/research/best-venture-capital-investments/): the next 50-100x+ returns.?

In this venture model, not only is volatility extreme, but because VC funds make relatively large investments in individual companies, the majority have highly concentrated portfolios of, at most, a few dozen investments.?Their overall performance, therefore, is largely predicated on the performance of the single best one or two investments in each fund.

However, if you were to design optimal portfolio construction from scratch, you would instead build an extremely large portfolio. The key reason for this is the statistical nature of the underlying performance of the asset, which follows a power law, which in a venture capital context means that a relatively small number of investments represent most of the industry’s total return.?

If you believe that the performance of venture investing is governed by a power law, then the optimal construction is therefore as close to infinity, in terms of the number of positions, as you can get.?

Specifically for pre-seed and seed stage investing: assuming a consistent minimum quality filter (in the case of Techstars, our accelerator application process), the more you invest, the higher the expected performance. In other words, placing more bets increases the odds that you get bigger and bigger outcomes.?

The second element, hyper-diversification, is far more straightforward.?By covering as many verticals as possible, from aerospace to Web3, in as many geographies as possible –?from mature markets such as the U.S. West Coast to rising regions like the Middle East and Africa –?as an investor you are exposed to the widest range of innovation globally, which in turn increases the odds of catching the next unicorns, and spotting the next innovation trends, as early as possible.

The net result of going very early, investing at scale and hyper-diversifying, is strong, stable returns, and low volatility, with better downside protection – the very outcomes that draw millions to index investing in the public markets.??

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