“This is the first time in history that non-bank investors can get access to unsecured consumer-credit products.” – Aaron Vermut
Just last month, I received an email from Van Eck trumpeting the merits of peer-to-peer lending. It was interesting to read that a $30 billion+ asset management firm would go on record to endorse the merits of the once relatively obscure peer-to-peer (P2P) lending space. All our clients and longtime Insight readers know that we are big fans of P2P (also called “marketplace”) lending. We first wrote about this investment opportunity back in the fall of 2013 with our post entitled The Hunt for Yield. We followed up with three additional posts (A Banking Phenomenon, Peer-To-Peer Is Here!, & Building A Better Mousetrap) to provide further information on this investment opportunity and to announce the roll out of our P2P managed account offering. As we now bump up against the three year mark of our initial foray into researching the P2P lending space, we thought it would be a good idea to write another blog post on this relatively young asset class and provide an update on how our P2P managed account composite is performing.
For those that are reading about P2P lending for the first time, we will provide a very brief recap of the space. P2P lending was first introduced back in 2006 as one of the first forms of crowd funding with the goal of cutting banks out of the consumer loan process. Since that humble beginning, the industry has gone through growing pains and a huge stress test during the Financial Crisis to now become one of the fastest growing sub-markets in the banking industry. The largest platforms in the P2P lending space are Lending Club and Prosper, although dozens more have sprouted up over the past several years. These platforms allow investors to crowd fund both consumer and business loans by committing as little as $25 to each loan. Since each loan is unsecured consumer debt, investors are advised to spread their investment capital over hundreds if not thousands of different loans to diversify the risk of default and fraud. There is a lot truth in the saying about there being safety in numbers when it comes to P2P lending.
The reason we became such staunch believers in marketplace lending is because we saw it as a chance to earn stock-like returns with bond-like risk. We build our portfolios using a blend of B-G grade loans which provide a gross yield to the portfolio of between 15%-16%. In our composite, which goes back 19 months at this point, we’ve seen average default rates running around 5% -6% which leaves a net return to the investor of 9%-11%. This range happens to be right in line with most scholars’ long-term return expectations for the stock market, but unlike an investment in stocks the return stream for a portfolio of P2P loans is very consistent with not much volatility. This is why the risk profile of a well-diversified P2P portfolio is more like a bond than a stock. The chart below shows the return stream of our P2P composite versus the Barclays Capital High Yield Bond index and the MSCI All-Country World Index for a stock market comparison.
As you can see in the above chart, the returns of the P2P composite portfolio are much more consistent and less volatility than those of either the high yield bond or global stock market indexes. The volatility in the return stream of our P2P composite has been less than 1/7th that of high yield bonds and 1/15th of the global stock market. In fact, our composite posted a positive 0.40% return last month during a very turbulent time when high yield bonds were off -1.6% and the global stock market was down -6.0%. In addition, the correlation of our composite to stocks and high yield bonds has been a very low 0.09 and 0.19 respectively. As a refresher, a correlation of 1 means two assets move in lockstep (perfect correlation) and a correlation of -1 means two assets move counter to each other (perfect inverse correlation). The goal is to be close to 0 which indicates assets are moving independently of each other.
That being said, January is one single month of market stress which may or may not be a harbinger of more stress to come. In the case of a prolonged period of market stress due to an economic recession, we would expect default rates in our P2P Composite to climb as people lose their jobs and are unable or unwilling to make their debt payments. That being said, we think it is still possible and highly likely for a well-diversified P2P loan portfolio to post a positive return or a small loss in this kind of environment compared to the large losses stocks traditionally experience.
We have seen an uptick in default rates in our portfolio over the past several months, which can mainly be attributed to the seasoning effect of the portfolio as loans age. Someone who is able to take out a new loan probably has the ability to make the payments right out of the gate, but as time goes on circumstances change and a person’s ability or willingness to make payments can change as well. Multiple studies have been done to show that default rates steadily increase and end up peaking once the portfolio hits the 12-18 month range. Beyond this point, most of the weak hands have been flushed out so default rates once again drop back down to average levels. We believe that default rates on our P2P composite will level out at around 5%-7% for a net return of 8%-10% in the portfolio.
Part of the reason we believe our portfolios will have slightly lower default rates versus an indexed approach to investing in marketplace loans is due to the additional underwriting we do when selecting loans for our client’s accounts. We have a very strict screening criteria which actually eliminates more than 90% of the loans that are approved on Lending Club’s platform. Since Lending Club only approves about 10% of applicants on their platform, that means that only 1% (10% * 10%) of initial applicants would even qualify for inclusion in our clients’ accounts.
Even though our track record is relatively short, we can already measure some of the impact our underwriting is having versus the broader universe of loans. The below chart shows the actual performance of one of the oldest accounts in our composite. The large blue dot shows the return on this account versus other accounts with similar yield and loan concentration on the Lending Club platform. Although it doesn’t look like much, the fact that the blue dot is hovering in the upper third of the distribution for accounts of similar age means that this account is earning an extra 1% - 2% over the average account of similar vintage and makeup.
Marketplace lending continues to grow in popularity with both individual and institutional investors. Van Eck’s recent endorsement of the industry further solidifies the thesis that P2P loans are a legitimate investment alternative for anyone looking to diversify their portfolio. As previously mentioned, when it comes to P2P investing there is safety in numbers, but on the flip side, there is often wisdom in not following the herd. P2P lending is a relatively young marketplace, but one that can provide handsome rewards and excellent diversification for those willing to challenge the traditional stock-bond paradigm. As NSR Invest recently pointed out in their monthly newsletter, Season Investments is here to assist investors looking for help in navigating the P2P marketplace.
Author Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.
Transparency is one of the defining characteristics of our firm. As such, it is our goal to communicate with our clients frequently and in a straightforward way about what we are doing in their portfolios and why. This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities. It represents only the opinions of Season Investments. Any views expressed are provided for informational purposes only and should not be construed as an offer, an endorsement, or inducement to invest.