What Would be the Ideal Way to Invest in Peer Lending?
The idea of lending money to people you don’t know, without any kind of guarantee, may seem stupid at first. But ‘Peer-to-Peer lending’ (as it was originally called) does work for investors. For years, origination marketplaces such as Zopa in the UK or Lending Club in the US have provided excellent returns to investors with low volatility.
Despite these great returns, the investment experience is not ideal.
The various Peer Lending platforms release a wealth of information when loans are originated and keep the data available for historical analysis, but accessing and using the data is arduous and quickly becomes a full time job. In short, transparency is good; complexity, not so much. Hopefully technology will soon bridge managing investments at a micro-level with the simplicity of a mutual fund or ETF.
One solution to simplify the experience is to blindly trust an origination platform’s risk algorithm and invest in either all of the loans, or only some of them, but at random. Such a strategy can give satisfying results (after all, average Lending Club investors get 7% net annual return) but is quite risky. And investors can always improve returns with a more careful selection.
Loan selection requires researching an investment strategy and then applying it, most of the time manually. Doing this for one platform can be cumbersome, as this research requires studying specific data. Adding to the complexity is the fact that each platform handles loan data differently, with specific loan properties and proprietary data formats. The complexity of the data often means that simple tools, such as Excel, aren’t enough, while other times the platform data is too new to do a complete analysis on and requires use of external macro-economic data to assess the risk-to-return profile.
As stated before, loan selection quickly becomes a full-time job. It should therefore be left to professionals. Ideally, those professionals would not over-charge for the gains in return they provide and have a fiduciary duty to put clients’ interests first.
The good news is that carefully constructed financial innovation and sophisticated algorithms do not necessarily mean increased complexity. You use Google Maps to show you the ‘best’ way between point A and point B, but you needn’t understand how it works. It shows you simple, clear directions and has gained your trust through reliability. Balanced with enough transparency, algorithms-based decisions can bring simplicity and trust.
A focus on verticals means a greater expertise and ability to assess risks. That means that over time the number of Peer Lending platforms should increase, up to the point of dozens (or even hundreds?) of origination platforms coexisting with each offering credit in niche areas. This offers a fantastic opportunity for diversification, because as stable as Lending Club’s returns are, it is still safer to build and maintain a portfolio across multiple platforms and sectors, including consumer credit, small businesses, real estate, and education. There are even a few initiatives to build Peer Lending marketplaces around verticals completely uncorrelated with the stock market or economic cycles, such as litigation lending.
While diversifying across platforms is safer, the downside is that investing in a new platform requires the submission of new credentials, which means that personal and sensitive information like one’s social security number must be transmitted over and over again.
And then research must be done on that new origination platform with its own loan properties. Again.
And then at the end of the year, the investor will receive separate tax documents from each platform.
Diversification should be more accessible. Ideally, one investment platform could both centralize all the required credentials and provide aggregated reporting and tax documentation.
In a move uncharacteristic of traditional financial institutions, Peer Lending platforms like Lending Club or Prosper have decided to be incredibly transparent and let anyone study the characteristics and performance of any of the over 2 million loans that have been issued so far. Such a decision is commendable since it vastly improved the credibility of Peer Lending. However, analyzing such a quantity of data is often beyond the capabilities of the average investor. We spent a lot of time improving reporting at LendingRobot, so that our clients can see tables and color-coded charts showing much of the details. One could hope for similar dashboards for all kinds of originators.
Bundling securities together to make them more manageable is an old practice, and eases trading between investors. Regrettably, ‘securitization’ is also an easy solution to hide more than a few rotten apples and rating agencies are of little help to asses the quality of underlying assets in such products, as painfully demonstrated in 2008. Therefore securitization, or pseudo-securitization, can only be a solution if it doesn’t compromise transparency.
Because they’re traded like stocks, Exchange Traded Funds (ETFs) look at first like an ideal solution for Peer Lending investments. But because they’re traded like stocks, it also means their price is largely based on investors’ appetite. The stock market has demonstrated numerous times that assets are not traded at their objective values; and analysts who value companies rarely agree what that value is. Out-of-fashion companies can be traded below book value; in some extreme cases, public companies may be valued less that the cash they have on hand. Furthermore, high-frequency trading and algorithmic trading now represent a huge majority of actions on the stock market, causing even more volatility. As a result, the performance of Peer Lending-based ETFs is somewhat uncorrelated with the performance of the underlying loans, which makes them a much risker investment.
One advantage of investing in private debt is to protect one’s investment performance from the vagaries of the stock market. Loan performance does not depend on the S&P 500, so neither should the return of a portfolio comprised of those loans.
Debt instruments have the advantage in that the shorter the maturity, the less risky they are (it’s safer to lend $100 to your cousin Bob for one week than one decade). This makes them excellent short term investments, which in turn makes the liquidity issue more acute.
When investing directly in an origination marketplace, the easiest way to liquidate is simply to cash out the loan payments and not re-invest. It has the benefit of simplicity and no extra costs. But a complete cash-out requires the investor to wait until the last loan matures, which means that the money drips back over months or years instead of being extracted immediately. This makes reinvestment into other asset classes harder.
Secondary markets for note trading, which currently operate on Lending Club and Prosper, give an investor who wants to cash out the opportunity to list their portfolio’s notes for sale. But the fact that the assets are fragmented (there are millions of unique notes, compared to thousands of unique shares for the stock market) requires price negotiation to be made on a case-per-case basis, a process that can last weeks without an automated system like LendingRobot. On top of that, selling notes incur a trading fee of 1%.
Liquidation is not easier when investing through a fund because liquidity is at the discretion of the fund manager, without any prior visibility as how much time it could take.
Instead of adding transaction costs by selling notes, the ideal process would be to, whenever possible, match the positions between the investors wanting to cash out and the people willing to invest. This would increase liquidity at no additional cost.
The more complex the structure to manage someone’s investment, the higher the operating cost. As more people and more intermediaries get involved, more money will be taken from the investor’s pocket. After all, people in the finance industry don’t have a reputation for working pro-bono. Thus, a delicate balance must be found between offering a good, simple service and charging reasonable fees.
With the investment management process becoming more and more automated, one would expect management fees to go down in response to gains in efficiency. At the bare minimum, management fees should not exceed any additional gains that the investment manager achieves for his clients. While the desire for this is obvious, it is seldom the case.
One big drawback of Peer Lending is tax inefficiency. Because interest on loans are considered short-term income, the effective taxation rate is significantly higher than for proceeds of investments in stocks or funds. While it is possible to shelter those gains in an Individual Retirement Account (IRA) so they can compound without being reduced by taxes first, IRAs constrain withdrawal options and are often tedious to setup. In an ideal world, gains for Peer Lending should be taxed like other long term investments.
Regulators want to protect the average person, causing investment companies to be subject to a wide variety of rules and regulations. Those deemed as “sophisticated” investors are usually given more leeway to be creative in their investment choices. Lacking any simple, objective way to gauge an investor’s sophistication, wealth is the proxy for determining if someone is ‘accredited’ to invest in fancy assets. The side effect is that the fanciest investment services and opportunities are restricted to rich people. Out of many Peer Lending marketplaces in the US, only a tiny handful are accessible to average people. And even for accredited investors, verifying this accreditation is usually a tedious process requiring communication of bank statements or tax returns. We have many clients at LendingRobot who are wealthy enough to be considered ‘accredited’, yet most of them balk at going through all the hurdles required by accredited-only marketplaces.
In summary, the ideal Peer Lending investment should be optimized as an investment class covering stable returns, diversification, tax efficiency, affordability, all while being easily accessible, liquid, and transparent. And while we’re not here yet, it is direction Peer Lending is heading towards.
- Alex Neporozhniy
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