Maximising Returns While Avoiding Volatility: Conflicting Aims? Not with P2P.
BMO Global Asset Management recently declared the sharp rise in volatility, as a consequence of the February sell-off, as a ‘systematic [sell-off] one rather than a correction’. While optimistic about equity markets in the imminent future, the asset manager still recognised that UK prospects looked subdued, particularly with Brexit looming. For investors, one of the biggest threats that your investment portfolio faces is the volatility associated with its components which can negatively impact performance, especially in the short-term. This begs the question: How do you maximise returns to achieve goals while avoiding volatility?
Market volatility snapshot
If we view the performance of the FTSE 100 over the last six months, we can see that a concentrated period of volatility (as displayed in chart 1) emerged earlier in the year.
Chart 1: FTSE 100 Volatility Ind, source FT.com
The knock-on effect was a significant 700-points drop in trading price from a 7,787 high on 12th January to 7,075 points at the end of the first week of February, ass illustrated in the chart below. This reflected investors apparent concerns surrounding the prospects of higher inflation and the FTSE 100 recovering strongly.
Chart 2: FTSE 100 Performance, source: Hargreaves Lansdown
UK equities prove unpopular
According to a Financial Times Special Report, UK equities experienced £532 million worth of net retail outflows in January 2018. The lack of appeal for the London market was compounded when Merrill Lynch published the results of a survey it had undertaken:
“In April, a Bank of America Merrill Lynch survey of 176 global portfolio managers responsible for $543bn of client money found that UK equities were deemed the least attractive asset class anywhere in the world.”
From our perspective as a specialist in peer to peer lending, it’s clear that investors have been turning to P2P to gain exposure to a fixed income alternative and to balance their portfolio with a stable and predictable asset class, diversifying away from equities.
Gaining exposure to uncorrelated yield
Diversified lending provides a strong combination of delivering consistent and predictable returns with low volatility, comparative to other mainstream asset classes.
The characteristics of the asset class lend themselves to investors seeking to balance their portfolio with stable yield.
Because the underlying loans made to P2P borrowers (business, consumer, property) do not sit on an exchange, they are not highly exposed to market volatility or correlated to other asset classes in your portfolio. Therefore, your investment shouldn’t suffer from large swings in the market; as volatility increases and markets correct, your P2P investments should still perform well.
Risk warning: Past performance is not a reliable indicator of future performance. Peer to peer lending is not covered by the Financial Services Compensation Scheme (FSCS).
Investor behaviours demonstrate appeal of P2P as a diversification tool
In a blog post we published a couple of weeks ago, I frequently referenced a recent Cambridge University report - Entrenching Innovation 4th Alternative Finance Report - when discussing investor motivations and behaviours in P2P. I’ve chosen to use the below graphic again to further illustrate the important role P2P plays in diversifying investors’ portfolios.
As we can see, ‘Diversify my investment portfolio’ is considered the 3rd most important reason for investing in the asset class, with nearly 90% considering it to be an important or very important factor.
Figure 1: Investor Behaviours and Motivations, source: Cambridge Report
When considering the top three factors which influence an investor’s decision to invest in P2P, you can make a strong case for P2P being an asset class which delivers attractive returns while avoiding volatility: the 1st and 2nd most important factors influencing an investor’s decision to invest are to ‘Make a financial return’ (1st) and ‘Available interest rates’ (2nd). While the graphic doesn’t explicitly state ‘volatility’ as an influencing factor, it can be reasonably assumed that it forms the rationale for diversifying a portfolio into P2P.
P2P lending risks
While a largely uncorrelated investment, P2P is conversely considered an inherently illiquid asset class. Buying and selling loans is facilitated by the major P2P lending platforms but is reliant on new investors substituting loan commitments to enable early access to funds. Investors should generally be prepared to hold their loans to maturity and view P2P as a longer-term investment.
Moreover, without adequate diversification, you may suffer from platform concentration (investing with one or two platforms only) or sector concentration. A well-balanced portfolio of different P2P providers, offering exposure to different sectors, is recommended.
Investors seeking to balance their portfolio with stable returns are looking to peer to peer lending, where returns in the region 5% per annum or greater can be achieved without exposure to volatility. Diversifying further within P2P is recommended to avoid borrower, investment provider and sector concentration.