Neo: I don't like the idea that I'm not in control of my life.
Morpheus: I know exactly what you mean. Let me tell you why you're here. You're here because you know something. What you know you can't explain, but you feel it. You've felt it your entire life, that there's something wrong with the world. You don't know what it is, but it's there, like a splinter in your mind, driving you mad. It is this feeling that has brought you to me. Do you know what I'm talking about?
Neo: The Matrix.
Something is wrong, very wrong, at the heart of the investment advisory industry.
Many of my most astute colleagues, who like your author have more than two decades of experience in private banking advising high net-worth clients, know in their hearts that something has gone awry in our trade. Far from improving, the situation is worsening, and the very tools of our profession (deposits, stocks, bonds, annuities) are increasingly inadequate to build a portfolio for our clients that will satisfy their fundamental needs for capital preservation plus reasonable, low volatility growth over time.
Like Neo in “The Matrix”, we face a choice. We can take the blue pill and ignore these doubts about our current toolkit. We can take comfort in empty concepts such as “stocks for the long term”, “buy and hold”, or “value at a reasonable price” or the misleading “value at risk (VaR)” methodology. We can continue on our merry way, hoping that things will work out eventually, despite the increasing body of evidence to the contrary.
Alternatively, we can choose to take the red pill, admit that we need free our mind of outdated concepts in order to find better tools and methods to serve our clients, and get to work to find solutions. This article is written to motivate investment advisors to have the courage to take the red pill and embrace Alternative Finance for the benefit of their clients.
Investors, or Savers?
One of the fallacies that has enslaved the minds of investment advisors is the idea that their clients are “investors”. My experience is that this is patently false. Warren Buffet is an investor, George Soros is an investor, but most of our clients are in fact simply savers, even if they can correctly be profiled as “sophisticated investors” and hold substantial wealth. They hold for one reason or another an accumulation of financial wealth that is not needed to finance their living expenses in the short or medium term (though it may well be needed for retirement) and seek to earn a reasonable return on this money. A “reasonable return” for most would a few percentage points above the current inflation rate in their base currency, but crucially with a primary emphasis on capital preservation.
Most clients would be perfectly satisfied to earn this sought-after return on their capital through bank deposits, and have done precisely this until very recent years. Here the bank serves its classic function of paying a reasonable interest rate to take deposits from those who have a surplus of money, and charging a somewhat higher interest on loans issued to qualified borrowers who have a deficit of money during a given time period. This is a win-win situation, as the savers earn a return on their hard earned savings, while the bank serves as an intermediary to allocate this surplus capital to consumers and business people to enable them to finance their purchases or investments to grow their businesses.
Bank Deposits No Longer an Attractive Investment
In recent years this model, so essential to our economy, has to a large degree ceased to function. Central banks throughout the developed world have pushed interest rates to historic minimums hoping to stimulate sluggish economies and lower chronic high unemployment rates. Returns from bank deposits both in the US and Europe are now rarely above 1% per annum. The lost interest income to those who save through bank deposits has made a dramatic impact in any reasonable estimate of the amount of money necessary to provide sufficient income for a secure retirement. The official and lasting policy of low interest rates in the developed countries has forced many savers to move from the security of the government-insured bank deposits to assume a much greater risk as investors in the capital markets in order to attempt to earn an acceptable return on their savings.
Bond (and Annuity) Yields at Record Lows
A further problem for our clients today, both savers with bank deposits and investors in the capital markets, is the extremely low returns offered not only by bank deposits, but also by fixed income instruments, due to the consequences of quantitative easing. Simply stated, quantitative easing has distorted price signals of all kinds, not only for government bonds, but also for corporate bonds and shares. As central banks have purchased government securities in massive quantities in recent years, interest rates on all fixed income instruments have been driven down to historically low levels. At the same time, stock prices have risen to lofty new highs due to the increase in margin lending, and low bond yields have driven money into the stock markets in search of returns even at the expense of far greater risk. Fixed income yields have been driven down even further as banks have joined the central banks as major buyers of government bonds in recent years. When banks buy government bonds of their home country they not only do a favour for the political leaders seeking to finance the government deficit as cheaply as possible, but also earn a zero risk return as they deploy their depositor´s capital in a way favoured under the new banking regulation rules of Basel III.
Unknown Risks: The Real Problems for Savers entering the Investment Markets
To return to our starting point, what is wrong at the heart of the investment advisory industry today? The answer is the overwhelming prevalence of totally unforeseen and unknown risk which should never be assumed by clients who value preservation of capital before any other consideration. Savers who leave the shelter of deposits in the banking system to seek higher returns through investment in stocks or bonds are faced with a gamut of risks that can be neither fully disclosed nor mitigated by their investment advisor. This is because these risks are simply unknown and arise from totally unexpected quarters as the investment markets for bonds and shares are impacted by events around the world. In my career as an investment advisor I have seen “once in a century” events taking place in the financial markets at least four times, originating in such unexpected places as Russia in 1998 or American mortgage-backed securities in 2007. Furthermore, comforting concepts such as Value at Risk (VaR) are a fallacy, as they are based on the assumption that the distribution of investment returns over time follows a normal bell curve. This is not the case, as extreme events with profoundly negative consequences for the stock and bond markets occur with much greater frequency than is indicated by the models. In short, risk for substantial loss of capital in the stock or bond markets exists at all times, and for this reason these markets do not satisfy the needs of the vast majority of savers whose primary objective is capital preservation, even while seeking a reasonable return on their capital.
The Rise of Alternative Finance, Direct Lending and Bank Disintermediation.
Even as banks fail to offer attractive rates for savers, they also are unable to provide many of their clients with affordable consumer and small business loans due to the enduring consequences of the recent global financial crisis. New banking regulations, both through new domestic laws as well as the more stringent international banking reserves requirements of Basel III have caused banks to pull back from lending activities to all but the largest and most solvent borrowers. Consumer loans, small business loans, trade finance loans, real estates loans, in fact, loans of all categories normally financed through the banking system have been curtailed or even eliminated by many banks as they have reacted to the combined impact of new banking regulations and Basel III by refocusing their business on only their largest corporate clients.
In short, the current situation is one where savers are unable to obtain reasonable returns neither from safe bank deposits nor from much more risky investments in the fixed income markets. At the same time, those who need financing, consumers and businesses, are often unable to obtain loans from these same banks. This situation, combined with the ability of internet based platforms to efficiently and directly bring together savers and borrowers, has given rise in recent years to an entire new industry outside of the banking system, which allocates capital without the intermediation of banks.
Whether known as Peer to Peer Lending (P2P), Peer to Business Lending (P2B), Direct Lending, Crowdlending or the more general term “Alternative Finance”, this new industry is growing at an exponential rate and has huge implications for the asset management industry in the medium and long term.
Direct lending allows savers to obtain a return on their capital far superior to that offered by bank deposits, fixed income investments in the capital markets, or from dividend-paying shares in the much riskier stock market. In the United States and Great Britain especially, there are now dozens of consolidated platforms with multiyear track records of successful operation, providing funding to consumers and small and medium sized businesses. Through disintermediation and operating without the legacy costs and suffocating bureaucracy of the banks, these efficient platforms are profitable while charging only a small fee for their services of selecting qualified borrowers and maintaining a transparent and smoothly functioning marketplace between savers and borrowers. The result is that savers gain a return on their capital that reflects the true value of their money over time, as well as being far superior to the current extremely low interest rates from bank deposits and investment grade bonds.
The rate of return available to savers varies from platform to platform, depending upon the loan type and quality, the financial strength of the borrower and whether the loan has recourse to other assets in case of non-payment. Several years of available data demonstrate that the real return available for savers from a well-diversified portfolio of direct loans is typically in the range of 5% to 10% per annum, even after taking into account defaults from lenders who fail to repay their loans. This range seems unduly generous only in the light of the exceptionally low interest rates of recent years resulting from the distortions introduced by actions of the central banks. In fact, 5% to 10% per annum represents nothing more than the historical true value of money under normal circumstances. This range is also what those who need to take a loan for consumer or business purposes are gladly willing to pay, or are already paying to their banks when financing is available, and often much more.
Where are the Alternative Finance Investment Advisors?
Given that these attractive returns are available through direct lending in the new alternative finance space, why do investment advisors rarely if ever recommend direct lending to their clients? Why do they remain trapped in the current matrix of inadequate tools to build portfolios for their investors? Firstly, most investment advisors have yet to learn of the very attractive opportunities for their clients presented by direct lending as they continue to focus on what they already know, which is basically deposits, bonds and shares. Secondly, the vast majority of investment advisors in fact are not independent, but rather work for banks and investment advisory firms that are perfectly satisfied with the status quo, which is profitable for banks, asset management firms and advisors, even if this is not the case for the clients. Finally, until very recently, participation in alternative finance required that the client directly open an account in one or more of the online platforms and manage their loan portfolio personally. While this is adequate for many people, it is not an attractive option for those who do not want to personally dedicate substantial amounts of time to follow their investments online. Managed accounts in existing platforms, alternative finance focused mutual funds and ETFs supervised in respected European jurisdictions are the solution for these clients. These instruments will become increasingly available in coming months both in the UK as well as in Continental Europe.
A Better World of Efficient Capital Allocation between Savers and Borrowers
It is time for investment advisors to take the red pill, break free of the matrix (and in too many cases conflicts of interest between the needs of their employers and the needs of their clients) in order to guide their clients to the new asset class of direct lending. It is here where investors can earn reasonable returns on their capital while assuming only a single, quantifiable risk, that is, credit risk. Unlike the host of unforeseen risks that face investors in the interconnected and fully globalized stock and bond markets, credit risk for savers in alternative lending can be accurately measured, and it can be mitigated through broad diversification and careful selection of borrowers.
A new investment horizon, one beyond the constraints of the current investment advisory matrix, is becoming visible, where our clients can earn reliable and worthwhile interest rates through participating directly in the real economy, bypassing the banks, with a mix of alternative finance investments including Peer-to-Peer (P2P) loans, Peer-to-Business (P2B) loans, factoring/discounted invoice-based loans, trade finance loans and mortgage-backed lending, just to name a few categories. These clients will not only benefit by earning higher and more reliable returns on their capital, but will also have the satisfaction of knowing that their savings are serving to benefit the real economy through funding consumers and businesses. The success of their investment strategy will depend almost exclusively on the control and mitigation of credit risk and will be independent of the market gyrations resulting from the impossibly complex interactions between economic growth forecasts, projections from investment banks, proclamations from the central banks and purchase and sales by hedge funds and high frequency traders that determine returns in current stock and bond markets.
A rebellion has begun against the current comfortable status quo which serves the needs of banks and investment advisory firms to generate fees and governments to secure low cost deficit financing, but fails to satisfy the basic needs of our clients. The time is now to escape from the Matrix and begin to bring the benefits of the direct lending/alternative finance revolution to our clients through accepting this new asset class into the standard toolkit of the investment advisory industry.