Should You Invest Through Peer To Peer Lending Platforms?

Last update on Dec. 4, 2017.

Image Credit:Syda Productions / Shutterstock.com

 

At the beginning of every month, I brief members on how MoneyGeek's Regular portfolios have performed and comment on the state of the financial markets. In this update, I’ll also share my thoughts on investing through a peer to peer lending platform such as Lending Loop.

 

November Performance of Regular Portfolios

The performance of MoneyGeek's Regular portfolios for the month of November 2017 were as follows:

 

Last Month

Last 12 Months

Since Apr 2013

Slightly Aggressive

+2.8%

+14.2%

+96.0%

Balanced

+2.4%

+12.6%

+79.7%

Slightly Conservative

+2.1%

+10.9%

+64.3%

Moderately Conservative

+1.7%

+9.1%

+50.0%

Very Conservative

+1.4%

+7.5%

+36.6%

I've chosen to list below the performance of some of our competitors. For the sake of brevity, I've decided to show only those portfolios that have a similar risk profile to MoneyGeek's Regular Slightly Aggressive portfolio.

 

Last Month

Last 12 Months

Since Apr 2013

RBC Select Aggressive Growth

+1.4%

+15.2%

+68.2%

TD Comfort Aggressive Growth

+1.2%

+10.9%

+53.0%

CIBC Managed Aggressive Growth

+1.4%

+14.6%

+59.0%

Canadian Couch Potato Aggressive

+1.3%

+15.8%

N/A

In contrast to our competitors, MoneyGeek’s Regular portfolios employ stocks/ETFs that follow the value investing strategy (QVAL, IVAL and BRK-B), and also allocate a larger percentage of the portfolios toward Canadian oil and gas stocks (XEG.TO) and gold (CGL-C.TO). If you would like to take a look at our portfolios, I invite you to sign up for our free membership.

Regular portfolios outperformed their competitors in November. This was largely thanks to QVAL, which went up by 10.2% during the month. QVAL currently holds a significant number of stocks that pay high tax rates. Those stocks jumped at the end of November, as it became more likely that the Republican tax bill would pass, thereby reducing taxes.

The anticipation around the passage of the tax bill lifted the U.S. stock market overall in November. Virtually everyone now agrees that the stock market is expensive, but most continue to invest in stocks given the lack of alternatives that would generate acceptable returns.

In this type of environment, it’s tempting to take some money out of traditional investments like stocks and bonds, and put it into “alternative assets”. One such type of asset is a small business loan provided by peer to peer lending platforms like Lending Loop, whose CEO I interviewed recently. For the rest of this article, I’ll give some thoughts on investing through such platforms.

 

Expected Returns

One of the first things you might notice when you log into Lending Loop is that interest rates on loans are high. The rates offered typically range above 10% per year, far above what you can currently get from investing in government Canada bonds (1.6% per year), or high quality corporate bonds (between 2 and 3% per year).

But of course, there’s a catch. You only receive the high rate if the borrower doesn’t default, and unfortunately, we can expect the default rate to be high with loans such as these.

If a business has a solid financial history, it can get loans at a much more favourable rate from a bank. For example, I regularly receive pre-approvals for corporate lines of credits from my bank. I can’t remember the exact interest rate offered, but it’s definitely less than 6%.

Therefore, when a small business turns to a peer to peer lending platform, it does so because it either can’t get similar loans from a bank, or because it’s already maxed out on the amount a bank is willing to lend. Both scenarios imply a high risk of failure for the business.

Empirical evidence supports this view. The largest peer to peer lending platform in the U.S. is LendingClub. According to LendingClub’s statistics, the average interest rate on all loans issued last quarter was about 14% per year. However, the typical LendingClub investor only receives about 3.2% per year in returns.

If you want to receive significantly better returns than 3% per year, you’d need to discern which borrower will pay you back, and which borrower won’t. Unfortunately, this is a difficult task.

To see why this task is difficult, let’s assume the opposite and say it’s actually easy. If so, the banks should be able to figure out how to predict a borrower’s success. Then, the banks would incorporate their findings into their loan approval processes, and lend to would-be successful borrowers at lower rates than what a peer to peer lending platform can offer. If that happened, those borrowers would not show up on a peer to peer lending platform, and we’d never be able to lend to them.

Of course, saying a task is difficult is not the same as saying it’s impossible. I think someone with the right approach can potentially generate decently higher returns than 3% per year. For example, someone might be able to train a machine learning algorithm that predicts potential defaults better than a bank can. I also think it’s possible for someone to undertake some rigorous manual research and find commonalities shared by successful borrowers.

But regardless of the approach, one would need a lot of data to be able to hone his or her approach. Unfortunately, I don’t think there’s enough data available through Lending Loop or any other Canadian peer to peer lending platform that I know of. At least, not yet.

This means that realistically, I expect an investor to generate returns in the region of 3% per year by investing through a peer to peer lending platform. The question now becomes, is 3% per year enough? I’m not sure.

 

Portfolio Considerations

On the one hand, 3% per year is higher than the returns you’d get by investing in a government bond. However, while you’re more or less guaranteed to see returns from investing in a government bond, you’re not similarly guaranteed that 3% per year in returns. If you happen to choose some bad borrowers, your returns could be far less.

You could mitigate the risk of choosing bad borrowers by spreading your money among many different borrowers. While this approach would save you from concentrating your money on bad borrowers, it wouldn’t save you from an economic downturn, during which time businesses will fail more often than normal.

Since stock prices tend to go down during economic downturns, I’d expect returns from the small business loans to suffer at these times. Thus, I’m skeptical that small business loans would offer substantial diversification away from stocks.

Given the lack of data around loans and their high expected correlation with stocks, I’ve personally decided not to invest through a peer to peer lending platform. However, I do believe that small business loans could make sense for someone else, and I will re-evaluate my position once more data becomes available.

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