Risks vs Rewards of Marketplace Lending

There have been a lot of changes since Marketplace Lending was introduced in 2006, but since surviving the financial crisis of 2008 and SEC scrutiny in 2008-2009 it’s clear that Marketplace Lending is an asset class that is here to stay.

But where does Marketplace Lending fit into the grand scheme of your investment portfolio? What are the risks and challenges to consider, and what kind of return should you expect?

Let’s talk Portfolio Theory

Your risk tolerance and personal circumstances determine the amount to invest in marketplace lending. In simple terms, you will want to have some assets with a lot of upside (i.e. stocks), some assets that have lower risk and steadier returns (i.e. marketplace lending and bonds). You want to balance your assets in a way that you are as successful as possible over your specific time frame.

Modern Portfolio Theory is a finance method that says that for every level of return there is one portfolio that offers the lowest possible risk, and for every level of risk, there is one portfolio that offers the highest return. So, how does Marketplace Lending fit into that portfolio?

As an investment asset, Marketplace Lending returns have very low correlation with stock market fluctuations. This means that regardless of if the stock market goes up or down (remember the ’08 crash, or the subsequent recovery?) you should receive a fairly consistent return from your investment in Marketplace Lending. This makes it a good asset in which to invest a portion of your investment dollars.

There are three questions to consider:

1) What return can I expect from Marketplace Lending?
2) What are the challenges / risks of Marketplace Lending?
3) What portion of my income should I be investing in Marketplace Lending?

Average Marketplace Lending Return

Lending Club states that the median return for investors who have invested in at least 100 notes, where no note value is greater than 2.5% of the total portfolio who invest from 24-30 months for investors is 7.3%/year.

LendingRobot has estimated that historically the top 25% of loans average a 9.53% return over the same time period, making good loan selection an important feature of your portfolio.

Risks and Challenges of Marketplace Lending:

As a comparison, the S&P has averaged 6% per year since 2006. But there are some risks to be aware of:

1) Inflation Sensitive

Inflation has the potential to significantly reduce return on fixed-income investments. This is true with bonds, and is especially something to consider when you invest in Marketplace Lending. There are two reasons:

1) No early-repayment penalty

That nice 16% APR loan you funded could get repaid tomorrow if the borrower’s interest rate falls, since the borrower has incentive to borrow at lower interest rates and pay off their higher loans first. If interest rates for the entire loan market fall, the next loan with the same risk will also be lower, which will eat into your returns.

2) Interest rates don’t rise with inflation

Conversely, if the fed raises interest rates to 5%, that 16% loan may be the last loan the borrower pays off. This means that instead of being able to take advantage of loaning at higher interest rates, you are essentially waiting for the borrower to repay their loan before you can earn a higher return.

Now, unless you are Janet Yellen, you can’t do anything about the US inflation rate. This means that the way to achieve better inflation-adjusted returns is to diversify into liquid asset classes that fluctuate with inflation, or be selective in the loans you purchase. However, both of the above issues are mitigated somewhat by the fact that, unlike long-term debentures, the loans have only a term of 3 or 5 years, with principal paid monthly instead of at term.

2) Non-systematic Risk:

Non-systematic risk is the hazard inherent in each investment. Marketplace Lending is not FDIC insured, so catastrophic collapse of a marketplace will cause loss of principal.

Non-systemic risk is a bit different for Marketplace Lending than other assets, since by definition Marketplace Lending is a centralized database containing records of each loan and all the borrowers. Two examples of non-systemic risk for Marketplace Lending:

1) Highly trained hackers get into the marketplace lending database and alter records, steal information, or bring the marketplace down. Any of these would be detrimental to your portfolio value.

2) The marketplace goes bankrupt. From Lending Club’s Prospectus, page 16:

“In a bankruptcy or similar proceeding of us, there may be uncertainty regarding the rights of a holder of a Note, if any, to payment from funds in the clearing account. If a borrower has paid us on a Loan corresponding to a Note before a bankruptcy or similar proceeding of us is commenced, and those funds are held in the clearing account and have not been used by us to make payments on the Note as of the date the bankruptcy or similar proceeding is commenced, there can be no assurance that we will or will be able to use such funds to make payments on the Note. Other creditors of ours may be deemed to have, or actually have, rights to such funds that are equal to or greater than the rights of the holder of the Note.”

Prosper has added additional safeguards to ensure that investors get paid first in the event of a bankruptcy, but as they state in their prospectus “… principal and interest payments on your Notes may be substantially impaired,”

Placing a large portion of your investment in any particular asset increases your overall risk, and the solution is to diversify into multiple asset classes. In roulette terms, don’t put all your money on black.

3) Lack of Liquidity

The secondary market is small and specialized, and loan values do not have set prices. This means that the value of your portfolio and ability to cash out may be limited. From Lending Clubs prospectus, page 21:

“Investors may be unable to resell their investments at desired times or prices, if at all. Note investors can only sell their notes through the resale trading platform operated by FOLIOfn Investments, Inc. (FOLIOfn), an unaffiliated registered broker-dealer. During 2013, it took an average of approximately four days to sell a note on FOLIOfn with an offer price at or below par.”

4) Cash Drag

There is a largely-hidden problem in Marketplace Lending known as cash drag. This is the effect that idle, or non-invested, cash has on your portfolio, and it can put a serious damper on your overall portfolio return.’

For example:

You invest \$10,000 in 400 loans. Even if you are able to find enough good loans in a single day to invest the entire \$10,000, some notes will fail review and will not be issued. It can take several weeks for the entire investment to be deployed, and you will be receiving interest and principal payments nearly daily thereafter.

Over time, cash has a significant chance of actually causing a negative return due to the inflation risk mentioned in #1 above. Assuming you receive an achieve an average of 9.57% your investment, over three years, for every \$100 in idle cash you are losing out on \$33 worth of profit.

You can fight the cash drag in two ways:

1) Reinvest idle cash into more loans
2) Transfer the cash out of the account

Of course, transferring cash out of your Marketplace Lending account would only make sense if you were going to put it in an alternate investment.

5) Complicated

Humans are bad at estimating risk. In many states, becoming a loan officer requires a four-year bachelors degree with a specialization in finance.

There are 32 different filters you can apply to each loan in Lending Club. In order to maximize return and pick out the best returns, it takes a lot of time and brainpower to constantly pick out the best loans.  You will need to review four times as many loans as you purchase to pick out the top 25%.  At \$25 invested per loan, a \$10,000 investment will require 1,600 loan reviews.

That’s a lot of choosing. The extra sad thing is, by the time you’ve chosen the best loans, they’re probably gone.

Robo-advisors are starting to dominate the investment landscape; they make more intelligent decisions faster and with greater consistency than humans. You could compare Marketplace Lending to Chess: it takes minimal skill for a person to play and a lot of time and effort to master. Unfortunately for us, machines dominate everyone. The same is true in Marketplace Lending, where the best loans are often snapped up by trading algorithms in less than 30 seconds.

6) Idiosyncratic Risk

Neither Lending Club nor Prosper identify the individuals behind each loan they offer for sale. The loan could be to pay off a credit card, start a business, or maybe build a really big hot tub. As an investor, it is important to recognize that each note represents an individual asking for money, and each individual, regardless of their credit history, carries the risk of not paying back their loan.

This is why finance professionals call diversification the closest you can come to a ‘free lunch’ – spreading your investment across many different loans doesn’t cost anything extra, but it does significantly lower your risk for the same amount of expected return.

In Summary

A properly diversified Marketplace Lending account offers good returns, low volatility and low asset correlation, which makes it a good addition to an investment portfolio. Automating loan purchasing to pick out only ideal loans and cut down on cash drag will help to achieve an optimized Marketplace Lending account. The non-systematic risks associated with Marketplace Lending can be mitigated with diversification across asset classes; LendingRobot has calculated an ideal Marketplace Lending allocation to be between 12-14% of a total portfolio.