The Funding Circle auction process allows investors to decide what return they demand for a given level of risk. It is easy to observe this return as it is simply the interest rate at which an auction clears. We then set out to identify whether or not investors were demanding a higher return for certain risk factors, or indeed accepting a lower return for a reduced perceived risk – as you might expect them to.
We identified 15 factors that we imagined might have an effect on perceptions of risk. We then normalized each cohort for the various factors so that we could identify the effect that each specific factor was having on required returns. The results were staggering. Across the 15 factors only 2 offered a statistically significant range in required interest rates. In other words, investors only seem to care about two factors when selecting their loans. The factors in question were the Funding Circle credit score and size of the loan in question. Factors such as geographic location and industry segment offered no variance in required rates – suggesting that investors were not taking them into consideration as a risk factor.
So investors are discerning, but they only discriminate according to 2 out of 15 risk factors. Given the wealth of data at our disposal, we were then able to explore and assess how rational this behavior is. Funding Circle’s loan book dates back to 2010. As a result a significant proportion of principle has been repaid and defaults and recoveries are observable. As a result any investor can research the actual risk (as measured in the purest sense – by actual loss of capital) of various risk factors.
We therefore calculated the effective historic loss rate versus each risk factor. We found the results to be rather exciting.
Investors are right to discriminate according to the FC credit score. The historic performance of loans does indeed have a strong relationship with the assigned rating. With regard to size, the logic was less sound. Investors appear to require a lower prospective return in order to fund smaller loans, but there was no clear evidence that small loans were any less risky. But what excited us most was the discovery that, for various other factors – factors for which there were clearly higher or lower risks at stake – investors were in no way discriminating in terms of required return. This would suggest that with a certain amount of research an investor could favour some factors over others and significantly improve prospective returns.
Whilst I concede that it doesn’t take much to get us excited here at AltFi Data, not when it relates to data anyway, the opportunity here is significant. By applying an Internal Rate of Return (IRR) analysis across the entire FC loan book we were able to enhance our return by 132bps by de-selecting risky cohorts and thereby favouring others. That is to say that by simply ignoring segments that offer more risk for no extra return and favouring sectors that offered less risk for the same return we could significantly improve our IRR. For context, an equal weighted exposure to the entire loan book gave an IRR of 5.36%.
This proves that an active strategy can significantly enhance P2P investor returns (when armed with the unique and comprehensive historic information that FC provides to all of its investors). We of course hope that this article is significantly titillating. In fact, given our interest in ensuring that P2P markets are as efficient as they can be, we look forward to sharing the research with you, and indeed highlighting the relevant factors. But for that you will have to log back on next week…
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