As investors, we often discuss the benefits of diversification.
For example, we may think of splitting our investment portfolio into REITs, blue chips and small cap stocks. In reality, this is not asset allocation as all 3 groups are under the equity class – this is just diversification within one asset class.
Thinking of investing across asset classes is a useful way of thinking about diversification. By that, we mean putting money across asset classes (such as cash, equities, fixed income and commodities) in order to balance risk and returns as various assets perform differently in different market conditions.
But within the last decade, a new asset class has emerged. It’s called marketplace lending.
How Marketplace Lending works
Need to borrow a tidy sum of money? Some options may spring to mind: the friends and family plan, maxing out credit cards, or the traditional bank or finance company.
Now, imagine you could whip out your smartphone, answer some simple questions on an app, offer basic bona fides, and get an answer within minutes. If the latter sounds appealing, that could explain why, over the past several years, marketplace lending or peer-to-peer (P2P) lending has swelled in popularity.
Such marketplace or P2P lenders have leveraged low operating costs, fast time to market,, Big Data and other technology streamlined for a mobile generation to credit score borrowers and match them with savvy investors who are looking for yield. It’s a fast-growing financial model, Morgan Stanley Research estimates that marketplace lending can reach ~$290 billion by 2020.
How does Marketplace Lending achieve diversification
As an asset class, Marketplace Lending achieves diversification in two ways:
- Unique asset class that is uncorrelated with Bonds, Equities, Real Estate, etc.
- Ability to diversify investment across multiple loans
Let’s start with the first, in the US where Marketplace Lending has gone through economic cycles i.e., Zopa has survived through the financial crisis of 2008; marketplace loan returns have proven to be uncorrelated to bonds and equities.
Secondly, Marketplace lending has the ability to diversify across multiple loans. This lies in the concept of loan fractionalization, where lenders fund a small portion of each loan. This is an important concept to grasp, so let’s use an example:
An investor invests 100k baht in Marketplace Lending. This investment is spread across 20 loans, each with it’s unique credit score and loan terms.
Let’s assume that this portfolio of 20 loans earns a return of 10% annually.
So that’s 10% p.a. returns from 100k baht of your loan portfolio with regular cashflows (principal + interest) each month.
Now, the question becomes, what happens when loans default?
So let’s take the non-performing loan (NPL) rate based on a 2017 third-quarter Bank of Thailand report, as you can see from the chart below, % NPL to SME loans are at the highest of ~4.63%.
Taking this figure, this implies that 1 out of the 20 loans (assuming they are invested in loans that fund SMEs) would default.
So that still implies 9.4-9.6% p.a. returns from 100k baht of your loan portfolio, with regular cashflows (principal + interest) each month.
In view of these two diversification factors, we can see that Marketplace Lending can be classified as its own asset class and characterized as a source of very consistent, attractive, low volatility returns for investor.
How should you invest?
Choose a Credible Marketplace Lending platform
When deciding which platform to use, there are several things to consider. Investors should take note of the management team running the platform – those with relevant investment, technology and risk management experience are likely to perform. Next, look at the approach that these platforms originate loans and how they credit score borrowers. Finally, look for platforms that are transparent with loan investment offer i.e., what information (ratios, credit history) do these platforms provide investors? If a platform is transparent enough to share all this information, it should be a good place to start.
Spread your risks
To put it simply, if you only lend to four companies, a default could lock up or destroy 25 percent of your capital. If your loan is spread over 20-plus borrowers, each individual default has a much lower impact. You should always lend in small amounts and to as many borrowers as possible to spread your investment risks.
Limit your investments
As the Marketplace Lending is a new investment type, investors should gradually increase their exposure in this class. Any investment in Marketplace Lending should sit in a portfolio which includes cash, bonds, and equities.
Is it worth the risk?
The development of Marketplace Lending as an industry is a good thing for both investors and borrowers. In addition to contributing to Thailand’s business landscape, an investor can look forward to higher returns.
Stay tuned for future articles as this exciting asset class becomes available to more and more investors!
PeerPower is a marketplace lender based in Thailand. We currently serve Accredited Investors, and are working with the Bank of Thailand for P2P licensing to serve retail investors. We also conduct regular sessions for Accredited Investors to learn more about P2P lending. To find out more, register here.