A top venture capital firm hits a rough patch

(MoneyWatch) As we discussed yesterday, venture capital is one of the few (if not the only) asset classes or types of investment where we see persistence of outperformance. However, that doesn't mean the best will always continue to win. Highly respected firm Kleiner Perkins Caufield & Byers is demonstrating that.

If an election was held to name a "poster child" for outstanding performance in venture capital, Kleiner Perkins would likely win. The New York Times recently noted that during the dot-com boom, the venture capital investment firm "all but minted money, making prescient early investments in Netscape, Amazon and Google, delivering astonishing returns to investors. Along the way, it became a symbol of Silicon Valley." According to investors, their 1994 fund delivered 32 times the investors' money, the 1996 fund 17 times, and the 1999 fund six times. Unfortunately, since then, investors say that the 2000 fund, the 2004 fund and the 2008 fund all are showing losses. Let's take a look at how that performance stacks up to what an investor in public equities might have earned.

• Six ways to avoid expensive investment mistakes
• Why you should pass on private equity
• How you and your employer botch your 401k

Making an exact comparison is impossible, as I don't know the dates those funds were raised. However, we can look at the relative performance of what's perhaps the best public benchmark for venture capital. While VC firms like to compare their performance to that of the S&P 500 Index, a more appropriate risk-adjusted benchmark would be the performance of more similarly risky small value stocks. With that in mind, we'll look at the performance of the Fama-French Small Value index (ex-utilities) since 2000, 2004 and 2008 (when the three Kleiner Perkins funds were raised).

You can see how the performance hasn't stacked up as well lately. While Kleiner Perkins was losing money for investors with its big bets on clean energy (including an investment of over $100 million in the controversial Fisker Automotive), health care and technology in its three most recent funds, investments in less risky, more diversified, publicly available and totally liquid small value stocks returned 325, 103 and 53 percent, respectively.

And Kleiner Perkins wasn't alone in seeing its fortunes change. According to data compiled by Cambridge Associates for the National Venture Capital Association, venture funds returned 35.7 percent annually in the decade ending in 2000, but they lost 1.9 percent annually in the decade ending in 2010. By comparison, for the decade 2001-2010 the Fama-French Small Value Index (ex-utilities) returned 13.8 percent per year. This most recent evidence only reinforces the longer-term data which has shown that venture capital has underperformed publicly available small value stocks.

It's also worth noting that among Kleiner's investors are the Yale and Harvard endowments, the Ford Foundation, and venture capital funds-of-funds. The performance of Kleiner Perkins demonstrates that even in venture capital, it's dangerous to rely on past performance as a predictor of future performance. It also demonstrates the importance of diversifying the risks of active management -- something that's hard for individual investors to do without engaging a fund of funds and incurring another layer of expenses. And here's another problem for Kleiner Perkins' investors and for all those who hire active managers: How long do you wait before you decide that the manager has lost its touch? There's no good answer to that question.

The bottom line is this: Given the evidence that venture capital on average has significantly underperformed publicly available small value stocks, you would need to identify in advance the top 25 percent, or perhaps even the top 10 percent, of venture capital funds. Since investors don't live in Lake Wobegon, it's obvious that only a minority can be successful. Unfortunately, overconfidence will likely lead many to keep playing a game they're highly likely to lose. You, on the other hand, don't have to play. If you seek higher returns from your investments, the most likely way to achieve that objective is to invest in low-cost, passively managed funds and diversify that risk across the globe.

Image courtesy of taxbrackets.org.