21 June, 2017

Peer-to-Peer Lending as an Asset Class

There are many reasons why Peer-to-Peer Lending is an attractive stand-alone asset class for investors, institutions and non-institutional investors alike. Peer-to-Peer Lending has historically offered higher returns than have been available elsewhere, stable yields and customer-friendly investment platforms.

But where does it fit as part of a broader investment portfolio? How should investors think about Peer-to-Peer Lending as an asset class? and why should investment managers allocate part of their clients’ portfolios to it?

Institutional Portfolio Construction

Well, to answer some of these questions, we should take a look at some basic portfolio construction principles. Conventional wisdom, derived from modern portfolio theory, tells us that optimal portfolios are those which are as diversified as they can possibly be. One of the most famous applications of this in the world of institutional portfolio construction is David Swensen’s Yale Model (or the Endowment Model). What’s interesting is that as well as being a proponent for investing across the entire range of traditional asset classes on offer, the Endowment Model has had a growing focus on alternative asset classes.

Today, domestic marketable securities account for approximately one-tenth of the portfolio, while foreign equity, private equity, absolute return strategies, and real assets represent nearly nine-tenths of the Endowment. The heavy allocation to non-traditional asset classes stems from their return potential and diversifying power. Today's actual and target portfolios have significantly higher expected returns and lower volatility than the 1985 portfolio.

Source: Yale Endowment Website

This approach to multi-asset class investing has become somewhat of a template for institutional investment portfolios. It becomes easy to see how Peer-to-Peer lending might have a place in a portfolio which aims to be as diverse as possible while achieving superior returns. Below is an asset class map, showing the traditional and alternative asset classes which comprise a typical, institutional, multi-asset class portfolio of this kind. Peer-to-Peer Lending becomes part of the alternative credit bucket in portfolios. As an additional bonus, Peer-to-Peer Lending, can be relatively liquid when compared to many other alternative asset classes, which generally should allow for higher allocations.

Asset Class Map

Source: Orca

Non-Institutional Portfolio Construction

So, P2P slots in an institutional, fully-diversified multi-asset class portfolio nicely, but what about portfolios for the rest of us? Typically, it is fairly difficult for non-institutional investors to be able to access the world of alternatives, with the exception of personal, residential property. Even for some institutions, accessing the best deals can be tricky. This has led to portfolios that are largely comprised of highly-liquid, cost-efficient equities and bonds, for example in a 60 / 40 percentage split. In some portfolios there may also be some exposure to commodities. The recent advancement of technology, efficient passive investment vehicles such as ETFs and online investment platforms have provided ever easier access to this kind of portfolio. Now, this is where P2P steps into it’s own, as it finally provides broad access to the alternatives space. P2P platforms have now democratised the process of investing in alternatives and so individual investors can complement their existing traditional portfolios with higher yielding, uncorrelated alternative credit.

Peer-to-Peer within the Income Generated Asset Classes

Of course, to achieve a spot within the income-generating bucket of a multi-asset class portfolio, or indeed to simply be a part of a narrower, income-generating portfolio, Peer-to-Peer Lending needs to be directly compared to other income generating asset classes. Historically, it has held up remarkably, offering better risk adjusted returns than the rest of the line-up.

Source: Funding Circle, Lendit, 2016.

Peer-to-Peer platforms are able to achieve these superior risk adjusted returns thanks to their structural efficiencies. These platforms cut out the middleman (i.e., the banks) and are operating as new FinTech businesses, which leaves them free of archaic legacy technology and operating systems.

The Future of P2P as at Asset Class

It’s a common question we see - where does P2P fit as an asset class? It turns out that it’s actually a simple answer and P2P can easily fit into institutional and non-institutional portfolios. For institutions, P2P Lending is just another option available in the alternative credit bucket, which can be justified thanks to its attractive risk/return profile and relatively good liquidity. For non-institutions, P2P Lending has democratised access to alternatives, helping investors achieve greater diversification. However, there is still some nervousness surrounding the risks involved with P2P Lending, but as the sector grows and an ecosystem develops around it, we will see an emergence of education in the sector, independent research and due diligence tools, which will all contribute to helping establish P2P Lending as a mainstream asset class. And if P2P Lending as an asset class can continue to offer attractive, stable yields, with low correlations to traditional assets, it’s not difficult to imagine P2P can forge out a regular spot for itself in standard investment portfolios. Watch this space.