27 September, 2017

Why Is Diversification so Important in P2P Lending?

Why Is Diversification so Important in P2P Lending?

In 1952, Harry Markowitz, the Nobel Prize winning economist, described diversification as the ‘only free lunch' when investing. Within P2P lending, diversification, after all, is the only way that investors can reduce the risk characteristics of their portfolio without reducing the portfolio’s return expectations.

It’s easy to think about why this is the case: Imagine a number of publicly listed stocks, each with similar return expectations. Would you prefer to pick one of these stocks to invest in, or would you rather hold a portfolio invested across all of the stocks? It’s also important to remember that it has been long proven that even professional stock-pickers, as a whole, underperform the market. So a very sensible approach is to go for an efficient, fully diversified portfolio of all of the stocks, as the portfolio’s expected return is the same, but the risk of the portfolio being sunk by one of the companies failing or underperforming expectations, for whatever reason, has been significantly reduced.

Now let’s fast-forward 65 years from Markowitz’s claim and we’ll see that the same philosophy applies today. It’s exactly this way of thinking that has led to a proliferation of passive investment products which track broad indices (diversified portfolios of investments). Investors can now easily and cheaply access large baskets of equities, bonds or commodities by buying a single product, such as an ETF, instead of having to choose individual securities.

Diversification is effective at all levels of portfolio construction, from choosing which asset classes to invest in down to individual security selection. Indeed, diversifying one’s portfolio across multiple asset classes is one of the core concepts of modern portfolio construction and is a compelling reason to include an allocation to P2P investing.

Within the peer-to-peer asset class, there are three key ways investors can, and should, diversify their portfolio: platform P2P diversification; sector P2P diversification; and borrower P2P diversification.

P2P Lending Platform Diversification

One of the first choices investors in P2P lending need to make is, which platform(s) they would like to invest through. Performing due diligence on platforms can be timely and difficult and may actually put an investor off the asset class altogether, so any reduction of risk here is of particular importance. The challenge is made even more difficult due to the fact that much of the information out there on platforms has been written by the platforms themselves, making it tricky to form an independent opinion.

The risks faced by investors on the platform level include:

  • Platform insolvency: Platforms may become insolvent. FCA rules dictate that platforms must have sufficient plans in place to ensure borrower repayments continue, but such an event would likely cause significant turbulence to investors.
  • Fraud: Although FCA rules stipulate P2P platforms must segregate client assets from their own, Nesta reported in the 2015 report ‘Pushing Boundaries’ the potential collapse of one or more of the well-known platforms due to malpractice was the biggest risk to the growth of the sector.
  • Technology risk: The entire P2P industry is based online and a severe cyber security breach is a real risk. 51% of P2P platforms surveyed by Nesta in 2015 regarded cyber security as a factor that could have a detrimental effect on the sector.

The most efficient way for investors to mitigate platform risk is to obtain independent due diligence and to diversify their holdings to multiple platforms, which means that their portfolio is less exposed to a single platform collapsing or under-performing.

P2P Lending Sector Diversification

Another factor that investors should consider when selecting a platform, or a number of platforms, is the underlying borrower sectors that they will be exposed to. Broadly, the P2P investing and lending industry has three sectors: consumer lending, business lending and property lending.

There are a series of market risks associated with P2P investing in peer-to-peer lending and each can have different effects on each of the sectors. For example, if unemployment rates were to rise, this could have a severely negative impact on the performance of consumer lending, as defaults rate rise. Similarly, if property prices were to severely decline, the ability to recover losses from defaults on property lending would be negatively impacted. The most efficient way to protect your portfolio during different market environments is to diversify your portfolio across all three sub-sectors, reducing your risk to any particular set of economic factors.

P2P Lending Borrower Diversification

No matter which platforms or sectors an investor chooses, they will ultimately be lending their capital to one or more underlying borrowers. The key risk to an investor’s capital is that the borrower will default on their loan. As alluded to above, this could be due to a poor credit decision by the platform, or could be due to economic factors. Investors can mitigate the former by diversifying their exposure to platforms and the latter by diversifying their exposure to sectors. But, another way that investors can reduce their risk is to diversify across as many different underlying borrowers as possible, which mitigates the risk of idiosyncratic events affecting individual loans as much as possible. The more loans and borrowers an investor is exposed to, the more diversified they are and the lower the risk of the portfolio.

Some platforms have functionality which will allow investors to diversify portfolios easily and efficiently across many underlying borrowers. This is known as “autobid” functionality and works incredibly well on many of the big platforms. Other platforms allow investors to manually construct their own portfolios. Some investors may prefer to manually select loans, but it can create a large administrative burden to manage the allocation process, mitigate cash drag (caused by cash left un-invested in portfolios) and to monitor the portfolio.

P2P Diversification Conclusion

Unless an investor strongly believes in actively managing their own portfolio, a more passive solution which is efficiently diversified across platforms, sectors and borrowers is an incredibly sensible approach to investing in peer-to-peer lending. The issue is that the P2P investing and lending industry is still in its early stages and there are currently no out-of-the-box solutions to this problem. Investors can do it themselves manually, but building such a portfolio can be timely and difficult to achieve and can create a large administrative burden in terms of portfolio monitoring and reporting.

Orca’s investment solution, which will aim to help investors diversify their portfolios quickly and efficiently, will be launching later this year. If you are interested, please get in touch via our live chat (we're always available) or email, [email protected]