When I began this series in Altfi.com in June of this year, I compared market lending to a volcanic island emerging from the sea, a new and largely uncharted territory rich in opportunities for income investors. Those opportunities have multiplied and matured significantly even in the brief time since that first article was published.
However, even as a traveller to a new country must at times adopt a new language, or at a minimum learn new meanings and context for the words of the traveller’s own language, I am increasingly convinced that before marketplace lending can become a truly mainstream product in the toolkit of investors and investment advisors alike, a new language must be learned. I hope that this new language will replace at least some of the shopworn, and indeed discredited terms used by investors and investment advisors when discussing traditional financial investments such as bonds and unit trusts or mutual funds.
The first of these terms is liquidity. As commonly used in the investment arena, liquidity refers to the degree to which an investor can quickly buy or sell an investment without making a material impact on the price of that investment in the market. For example, any share quoted on the FTSE or NYSE will normally be highly liquid, as the volume of shares bought or sold by one particular investor is negligible in comparison to the total daily volume of shares traded. In theory at least, the investor can “get out” at any time at the current price. Of course, the catch is that, as has been amply demonstrated during the financial crisis, liquidity tends to suddenly vanish precisely when an individual investor most wants to “get out”, as this is when institutional investors are also selling massively. In true crisis conditions, even the most liquid stock and bond markets can effectively become very illiquid or even cease to function entirely.
When I present marketplace lending investment alternatives to investors and family offices, one of the first and most important objections I receive is that while the returns are very attractive as compared to traditional fixed-income, the investments are not appropriate because they are not liquid, meaning that they are not listed on an organized stock or bond market. It is my contention that liquidity is a much over-rated quality for investors. While a part of an investment portfolio should surely be held in very liquid investments that can be immediately returned to cash as any time, another part of every portfolio can be held in investments that while they cannot be converted to cash immediately, will become cash again in a reasonably short amount of time as they reach their maturity dates. For example, a portfolio of short term loans to businesses or individuals, as well as loans for factoring and trade finance, might have an average maturity of well under a year, and in many cases investments with maturities as low as 90 or 120 days. These investments will provide a flow in income as they mature that can either be re-invested, or used for other purposes if the investor needs liquidity. In conclusion, in order to benefit from the much higher returns available to investors in market lending as opposed to traditional bank deposits and bonds, it is necessary to design a portfolio with self-liquidation of maturing investments as the primary source of liquidity. The traveller must adapt to this new definition of liquidity, and not miss this opportunity through seeing market lending exclusively through the lens of traditional investment criteria.
A second key term in the new language of marketplace lending is risk. In traditional investing, risk is poorly defined using the proxy of volatility. An investor is told that the risk to their capital is measured by the annualized daily variations of the price of their stock, bond or mutual fund. After 25 years as an international investment advisor, I can confidently state that insofar as the needs of investors is concerned, this definition of risk it total hogwash. The daily variations in prices on the stock or bond markets are influenced by a multitude of factors, almost all of them of no concern whatsoever to the typical investor. However, when a financial crisis occurs, liquidity disappears and prices of even low volatility investments drop substantially, it is only then that investors are told that there has been a sudden ¨uptick¨ in volatility that was unforeseen, and not captured in models predicting future performance.
In fact, the only definition of risk that matters from the investor’s perspective is the probability of losing their money. In marketplace lending, this event is known as default, when the debtor fails to make the scheduled payments on the loan. This is far and away the most significant factor of risk to marketplace investors. The good news is that unlike in traditional investing, where everything from what Putin has had for lunch to the latest mumbling of the head of a central bank is a factor that investment experts tell us must be considered as potentially important for the performance of investments, in marketplace lending the default rate alone merits such scrutiny. Fortunately, the default rate is easily calculated, and the risk of default can be offset through careful loan selection, both by the platform issuing the loan as well as by the selection of quality loans by the investor.
The final term that needs a new definition in the context of marketplace lending is expected return. In traditional investing, expected return on an investment is defined to a large degree by analyzing and projecting forward historical returns, often accompanied by warnings that short term market fluctuations should be ignored in order to invest for the long term. This has proven to be the road to ruin for countless investors who held on in a market collapse during the financial crisis, as well as countless other times in the past. Too many times individual investors “in for the long term” have been very badly served as their stock or bond funds lost a large percentage of their value due to forced sales by fund managers faced with waves of redemptions from institutional investors.
In sharp contrast, an investor in marketplace lending has a very clear definition of expected return. In their case, the expected return is simply the interest rate of the loans forming the investment portfolio, less any expenses charged by the platforms or fund manager and losses due to defaulted loans. That is all. As defaults will subtract substantially from the return, it is crucially important for a marketplace investor to divide their savings among a wide variety and large number of loans in order to reduce the impact of any particular default. This is a much more comprehensible and practical way for investors to estimate their future returns on their funds than the hope for the best strategy that is offered by the traditional investment industry.
There are many other concepts in the terminology of the traditional investment industry that will need to be adjusted for use in the new world of higher and more predictable returns from marketplace lending. I look forward to addressing some of these terms in the coming year as I continue to comment in this forum on the development of market lending from the investor’s perspective.