Marketplace loans (MPLs), also known as peer-to-peer loans, are an exciting new asset class that provides investors with a variety of benefits that are not found in traditional fixed income products.
The MPL market has grown rapidly since the Great Recession, as post-crisis regulations have made it prohibitively expensive for banks to service many of their former customers. Agile financial technology firms have seized the opportunity, finding innovative ways to fill the gap and connect borrowers with lenders.
In this article we examine the top 5 reasons institutional investors and wealth managers should consider MPLs. We feel they are an excellent complement to a traditional fixed income allocation, as they both increase your portfolio returns and improve your diversification.
1. Higher Risk Adjusted Returns
The most important benefit to investors is that MPLs consistently deliver higher risk-adjusted returns than comparable fixed income products. There are two primary reasons for this, both of which are systemic and not likely to change. First, MPLs are originated via low-cost technology platforms rather than through high-touch banking relationships. This greatly reduces the cost per transaction, creating higher margins while still trimming the borrower’s rates. Secondly, most MPL borrowers are retail consumers or small businesses, both of whom are required to pay higher interest than large corporations or governments – even if they have the same probability of defaulting.
2. Sector Diversification
Another major benefit is that MPLs are a very diverse asset class. Platforms tend to specialize in a particular sector or industry, creating a broad range of choices for investors. A few of the major categories include consumer retail, small business, real estate, and receivables. And within each category, substantial variation exists. For example, retail platforms support borrowers from all across the credit spectrum, and the loans are priced accordingly. Likewise, small business loans can come from virtually any industry.
3. Geographic Diversification
MPLs also offer significant geographic diversity. For instance, MPL platforms in the U.S. do not restrict which states are open for investment, regardless of one’s home state, which means investors can lend to borrowers in regions where the economic drivers are largely unrelated. And of course there are MPL platforms all over the world, allowing investors to build global portfolios to further diversify their exposure.
4. Low Correlation
MPLs tend to have lower correlation with equities than traditional fixed income products, providing shelter in an economic downturn. Consider corporate bonds, for example. A firm with publicly traded debt will frequently also have publicly traded equity, and when their share prices decline the debt value will follow in lockstep. Because MPL borrowers tend to be individuals or small businesses, they have more idiosyncratic risk and will not be as directly linked to the overall business cycle.
5. More Data, Better Models
MPL platforms are built on innovative new technologies that capture a wide range of data about their customers. And since most individual MPLs are relatively small, there are millions of borrowers providing data points. Each platform has its own rich dataset with unique attributes, which allow investment managers to develop sophisticated analytics against each sector and/or geography. We use advanced techniques such as machine learning and artificial intelligence to complement our fundamental analysis, which greatly improves the strength of our analytics.
MPLs are an exciting new asset class, but they are still relatively unknown and not always easily accessible. To take full advantage of the opportunity, we feel it is best to work with a professional fund manager who specializes in the space and can construct a robust portfolio. In our next post we’ll discuss some practical tips for investing in MPLs.