With cash held at the bank slowly being eroded by inflation, many investors have been attracted to the enhanced return prospects offered by alternative – or ‘peer-to-peer’ – lending.
However, any investment where capital is at risk – such as alternative lending – is not covered by the Financial Services Compensation Scheme and should not be considered as a substitute for cash deposits. So, why should investors look at the burgeoning alternative lending sector? We believe there are three key reasons.
Firstly, ‘diversification’ is often referred to as the only free lunch available in investing. This essentially means investors should hold a variety of assets with different underlying risk drivers to ensure an entire portfolio is not dramatically derailed by a single factor or event.
Alternative lending is very interesting from this perspective, as it is one of the few income options available to retail investors that may be shielded from market volatility. This has grown in importance recently as many markets are currently trading at historically high valuations. Markets follow a supply and demand dynamic and the traditional asset classes are definitely vulnerable to sudden downside pressures in stressed market environments.
Institutional investors understand this, which is one of the reasons why alternative assets are popular with this segment of the marketplace – in areas such as infrastructure projects like toll roads or power generation. These alternatives can provide a steady return and the values are not directly dependent on the supply and demand dynamic.
Unfortunately, it can be difficult for retail investors to directly access these opportunities. Fortunately, the alternative lending space essentially offers similar characteristics. It could be one of the few ways a retail investor can diversify away from everyday market volatility and risk.
Secondly, income-seeking investors often have long-term predictable needs in mind when choosing investments – such as retirement income or school fees. Traditionally, investors have held a portfolio consisting of equities and bonds, alongside some cash.
The problem here is that many investors rely on gradually selling assets, in addition to the income generated, to meet long-term income needs. A major dip in the market is not necessarily a problem when accumulating long-term savings, as holdings generally recover the lost value over time. However, those investors obliged to sell holdings in a market downturn will forever lose the opportunity to recover the lost capital. The impact on long-term planning, such as retirement, can be dramatic. Alternative lending may avoid this pitfalls as investors may fund their income needs from regular repayments from their borrowers, and so may not need to sell assets in market dips.
Lastly, alternative lending can offer attractive returns relative to other investment options, as well as against cash at the bank. Funding Circle has achieved average returns for investors of 6.6 per cent, while ThinCats has delivered 7 per cent-8.5 per cent. Even if you are not an income seeking investor, alternative lending could make a valuable contribution to a diversified portfolio during the accumulation of wealth phase.
There are a number of different investment needs where achieving a balance between higher returns, which can shorten the time needed to achieve the goal, and volatility, which may unexpectedly delay it, are very important. For example, the investors saving for a home deposit. Another is a SIPP investor close to the lifetime allowance and is seeking to maximise the available allowance before retirement – without paying tax charges for exceeding it.
Of course, investors must remember there is the potential of illiquidity in alternative lending – so it is important investors are confident the money allocated will not unexpectedly be required before it is due to be repaid.
Stewart Cazier is head of retail at ThinCats.
Keep up to date with all the latest financial news and investment tips by signing up to our newsletter. Email subscribers will also receive a free print copy of Money Observer magazine