Diversifying your investment portfolio using Peer-to-Peer lending and the new Innovative Finance ISA

Perhaps the greatest key to successfully building a risk-managed portfolio is diversification. Diversification can take many forms; across asset class, across sector or industry, across geography – the phrase means different things to different investors. Traditionally, equities (stocks and shares) provided a greater overall prospect of long term capital appreciation and return, but carried additional volatility which many investors find uncomfortable; government bonds and bank savings accounts (including ISAs) offered a much safer haven for capital, but were hampered by lower long-term returns. For many investors, it was a case of creating a balanced mix of investments tailored to their exact circumstances, objectives and risk tolerances.

Over the past 10 years, peer to peer lending has emerged a form of asset class distinctly separate from the traditional bank saving and equity investing models – and potentially offers an alternative to the risk concentration which goes with direct buy to let property investing. Indeed, part of the reasoning behind the surge in popularity of peer to peer lending in recent years has been not just the (overall) strong returns on peer to peer lending, but the idea that for many, real performance has outstripped the returns that would have otherwise been achieved through cash saving.

Today’s investor should, in any case, seek to diversify his or her portfolio. As part of this exercise, many will want to consider that from April 2016, income received from peer to peer lending can be tax-free if the lending takes place within an Innovative Finance ISA.

No advisor would recommend that an investor deploy more of his or her capital into peer to peer lending than he or she is comfortable losing – as the sector is not covered by the Financial Services Compensation Scheme. A good advisor would instead recommend diversifying across a range of investment asset classes to suit that individuals’ circumstances. The key question to ask is ‘where does peer to peer lending via an Innovative Finance ISA sit on the risk spectrum?’ – particularly in the context of low Cash ISA interest rates and volatile equity markets.

What is clear is that the risks associated with peer to peer lending are very different to the risks associated with saving through a traditional bank or building society Cash ISA. The potential risks (and currently, the potential returns) are greater in an IFISA than in a Cash ISA, but a sensible position to take is that neither is a substitute for the other.

It is important to remember that the Financial Service Compensation Scheme, which underwrites savings in UK banks and building societies for individual accounts holding up to £75,000 (per individual saver, per institution) does not extend to cover cash which is lent out via peer to peer lending platforms.

This means that if an investor were to deposit £50,000 with one of the high-street banks in a cash savings account, and that bank were to fail, the Government has in effect underwritten the amount held and that investor would, regardless of circumstances, be fully reimbursed by the Government for his or her loss. Because peer to peer lending is not covered by the FSCS however, any amounts held under the Innovative Finance ISA will only be recovered to the extent that monies owed to lenders on the platform can be recovered.

Certainly, it is worth noting that many platforms are building up internal ‘reserve funds’ – money set aside by the platform itself to compensate individual lenders in the event that the platform (or one of its borrowers) were to fail.

Similarly, some peer to peer lending platforms actually credit-insure their loans, meaning that (theoretically) lenders’ capital is protected by an insurer. However, the price to the platform of insuring the debt will not be insignificant – and this cost will possibly have been passed through to the lender in the form of either higher platform fees, lower interest rates, or both.

Some of the peer to peer lending platforms have business models which attempt to reduce concentration risk by automatically diversifying each lenders’ cash across multiple borrowers – reducing the impact that would be felt were one or two borrowers to default on their repayment obligations.

Originally Published: Monday, December 14th, 2015
Updated: Friday, August 10th, 2018

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