The Case for Diversification across the Crowdfunding Risk-Reward Spectrum

Angus Dent
Posted by Angus Dent on 28-Apr-2015 09:55:33


Ten years on from the creation of the world’s first peer-to-peer lending platform, the alternative finance sector’s stupendous rate of growth has rendered it unrecognisable. This has been a decade in which cumulative funding by UK platforms has risen from under £50,000 to almost £3.4 billion, driven by a proliferation in the number of platforms in existence as well as in the scope of their models and products.

The factors that have catalysed the development of alternative finance and allowed the sector to shake off its “cottage industry” credentials are manifold and too broad to discuss in this particular post. Symptomatic of its increasing importance, though, is the level of interest with which national authorities have begun to approach it; the FCA stepped in with a raft of legislation in April 2014 to begin the process of regulating the sector, whilst the government continues to postulate the benefits of including P2P lending within the ISA framework. Both of these activities serve to validate the growth that has taken place and to further legitimise alternative finance as a new investable asset class.

Indeed, it is hoped that such high-level involvement will encourage those who have been watching the space’s growth from afar, such as the IFA community, who have so far trodden a cautious line, to begin to engage more readily with the sector for the benefit of themselves and their clients. Underpinning the reticence that can still be found in some quarters, though, is the question of how alternative finance should be approached as an asset class and included within an investment portfolio. After all, the growth that has taken place has engendered much greater complexity, with the numerous products now on offer carrying different rates of risk and return.

In my opinion, the answer is to look for diversification. Diversification is a central tenet of Modern Portfolio Theory and its benefits have been frequently extolled since the 1950s. In recent years, however, the concept has come under some scrutiny. Active fund managers who heavily diversify their funds are often lambasted as “closet-indexers” – those whose funds simply replicate the performance of their benchmarks, but at a greater cost to the consumer due to their hefty fees. As cheap passive investment vehicles such as ETFs become more common, it is argued that this approach is unsustainable and active managers should maintain a smaller, “conviction based” portfolio to achieve outperformance. Yet whilst the world’s foremost investor, Warren Buffet, conforms to this viewpoint, casting over-diversification by professionals as mere “protection against ignorance,” he acknowledges that the concept retains its relevance for those without his powers of prescience, namely individual investors. And with the majority of investors gaining exposure to alternative finance without professionally managed vehicles, diversification remains important.

Strategies for achieving diversification are potentially numerous, and could include spreading investments across different platforms, geographies, products and risk-grades. A well-constructed portfolio that adopts such strategies should grant good exposure to this exciting sector, whilst simultaneously mitigating the risk to the investor. For example, an investor might look to higher grade business loans, higher grade consumer loans, and loans secured against property as the low-risk bedrock of their portfolio. The next risk band might contain medium-grade business loans as well as loans facilitated by foreign platforms, which whilst achieving geographic distribution could also bring in the risk of currency fluctuation. Finally, the highest risk section of such a portfolio would likely be composed of equity crowdfunding propositions, which carry the greatest potential rewards of all but also a significant risk of failure.

Whilst lowering risk for the non-professional investor is perhaps the most obvious benefit of diversifying a portfolio in this way, it also serves to allocate investors’ capital in a way that is equitable and consistent with the aims of a sector that developed to bolster investment to individuals and undercapitalised businesses. With reference to businesses specifically, it has been estimated that there will be a funding shortfall for SMEs of £84-191 billion between 2012 and 2016 as traditional sources of finance remain stifled. Spreading investment across the spectrum of opportunities, investing in the debt and equity of diverse businesses at different phases in their growth cycles, which are united by their need for a cash injection, spreads the benefits of this new mode of funding. It is best for investor security, and best for the economy.

Topics: business, diversification, loan, p2p, portfolio, alternative finance, growth, invest, ISA

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