Asset classes have their own varying characteristics, such as level of risk and potential returns in different market conditions. Peer to peer lending is no different to equities, bonds, cash and other asset classes in this respect. However, the associated characteristics differ between them all and, depending on variances such as correlation, can enable investors to construct portfolios which optimise expected return based on a given level of market risk. In Modern Portfolio Theory, Markowitz proposes a theory that an investment’s risk and return characteristics should not be viewed alone, but should be evaluated by how the investment affects the overall portfolio’s risk and return. We discuss how peer to peer lending measures against other asset classes and, when considering investment portfolio diversification, how it can complement a blended portfolio.
Peer to peer lending risk/reward properties
There are a few key risks associated with peer to peer lending. These range from the operational health of the platform through to the inherent liquidity of the asset class.
A primary risk is borrower default, whether a function of stressed market conditions or poor credit decisions made by the platforms. Despite several P2P investments having the benefit of asset security, or in cases coverage from a provision fund, a significant number of borrower defaults occurring will cause turbulence to your portfolio. Moreover, yield compression has been experienced at major platforms like Zopa who adjusted its lending criteria and product-set last year in light of rising concerns surrounding consumer-credit.
Insolvency, fraud and technology breaches are core risks faced by platforms. If a platform were to become insolvent, the loan contract remains between the investor and borrower, and platforms are required by the regulator to have fully funded wind-down plans in place, however, investments will be impacted.
Peer to peer investments are made in the UK consumer, business and property markets. If unemployment rates rose, consumer loans will be impacted. If the property market dropped drastically, the value of the asset underwriting the loan may drop and affect the Loan-to-Value rate.
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P2P lending is considered an illiquid asset class. You should therefore be prepared to hold their loans to maturity. However, with several major platforms, accessing invested funds tends to be achievable fairly quickly under normal circumstances. Although it is entirely dependent on new investors substituting loan commitments, which is not guaranteed.
For the adoption of risk, investors experience benefits such as attractive, stable, and predictable returns.
Attractive risk-adjusted returns
P2P offers attractive risk-adjusted returns in the region 5% (avg) per annum depending on the investment. Rates of 10%+ can be achieved, if you are prepared to manually select loans and curate your own portfolio of P2P loans.
P2P lending allows investors to implement strategies which support their portfolio objectives. Most of the major mainstream platforms offer passive models, which diversify your capital between dozens of investors to mitigate borrower default risk. Other platforms offer active models, which support investors seeking alpha, but rely on greater due diligence and time management.
Perhaps a greater benefit is that P2P investments are not highly correlated; P2P agreements do not sit on an exchange. This means they do not suffer large swings in traditional markets unlike other traditional asset classes. In simple terms, P2P lending should perform better in a downturn and offer investors the stability their portfolio will likely require. In fact, Landbay (property-focused P2P lender) commissioned an independent asset valuation service provider – MIAC Acadametrics – to model how the platform would perform in poor economic conditions. The valuation found that Landbay’s expected loss rate would be 0.03% in normal economic conditions and 0.48% in poor economic conditions. Returns would drop 0.48%, but critically investors would not lose money.
NB: Landbay valuation is not representative of the entire peer to peer lending market.
Interested in investing with Landbay as well as other major UK P2P platforms through the Orca Investment Platform?
Where P2P lending can fit within your portfolio
Figure 1: Asset class map (Source: Orca)
Modern Portfolio Theory would attest that optimal portfolios are those which are as diversified as they possibly can be and will include allocations to a range of asset classes (such as those above). In our asset class map, you can see that P2P lending fits into the alternative credit bucket. Interestingly, it is P2P lending which has enabled retail investors to gain exposure to a credit-asset which would typically be reserved for institutions. This means that portfolios which may have been heavily weighted to highly liquid, cost efficient, lower yielding, traditional assets can now be complemented with higher yielding, uncorrelated alternative credit.
It’s the accessibility and efficiencies offered by the streamlined, online process of investing in peer to peer lending that enables this.
Moreover, when we compare the total annual returns against volatility (plotted below) of major fixed income asset classes, we see that alternative lending has outperformed the rest, delivering over 7% total return at a standard deviation of 0.2%.
Figure 2: Major fixed income assets annual returns v volatility (Source: Funding Circle, Lending 2016)
Risk warning: Peer to peer lending is not protected by the FSCS, your capital and interest are at risk.
Thinking about diversification
Diversification was described as the ‘only free lunch’ by Harry Markowitz, Nobel Prize winning economist, in 1952. By diversifying, you can spread risk while maintaining the return of your portfolio. Diversifying into peer to peer lending can be an effective way to introduce a higher yielding, stable asset class to your portfolio. It’s important to consider allocation, as peer to peer lending is an alternative investment which is not protected by the Financial Services Compensation Scheme. Moreover, building a well-diversified P2P portfolio is recommended. Diversifying your exposure across platforms as well as markets and borrowers will mean you’re not left directly exposed to some of the key risks outlined above.
The old adage of ‘don’t put all your eggs in one basket’ is still very much relevant today. With the emergence of innovative asset classes, like peer to peer lending, investors can complement their portfolios with stable yield. The P2P market has reached a stage of maturity where research is available to support due diligence and new structures are launching which provide simple, efficient means of accessing the asset class. Consideration over allocation is always recommended.