Portfolio Diversification for Crowdlending Investors

Why One Loan and Ten Loans Are Not the Same Risk

One loan and ten loans per investor constitute an entirely different risk profile. It is best shown through the following example. Supposedly, two investors each allocate 1,000 USD to a loan on a crowdlending platform. The first investor attributes the whole pool of money to one project, whereas another diversifies, spreading it across 10 projects while dividing the claims into smaller ones. Each claim now costs 100 USD. In the first case, if the borrower defaults, the investor may lose an entire 1,000 USD. If 2 out of 10 borrowers default while the second investor holds the claims in their portfolio, it would still only be 20% of their initial pool.

This example shows that the diversification of the portfolio addresses one of the investment risks, the risk of concentration. Diversification alone cannot completely eliminate the credit risk for an investor, but it can reduce the effect one default has on the entire portfolio. It does not automatically mean that holding more unrelated assets is safer since they can differ in their risk profile, timeframe, and composition. However, diversification may become a viable strategy of concentration risk mitigation.

Does diversification protect my principal?

No, diversification does not protect the principal. It can reduce the portfolio’s dependence on a single borrower, but it does not guarantee the individual borrower’s financial performance. Instead, platforms like 8lends try to introduce borrower risk mitigation mechanisms like the collateral to secure the loan; underwriting and due diligence; and BuyB, or buyback, to put a potential obligation to repurchase the loan in case of the borrower’s insolvency in a particular case. Yet the risks cannot be entirely eliminated, and there always exists a possibility of loss of capital.

How Much of Your Portfolio Should Sit in One Loan?

In order to calculate how much of the portfolio should sit in one loan, it is feasible to conduct a simple calculation. The formula below allows us to do it.

Position share = Amount invested in one loan / Total crowdlending portfolio * 100

Supposedly, the investor has different portfolios. One has 10 positions for 100 USD each inside a 1,000 USD portfolio. It means that each claim individually represents 10% of the portfolio. In another portfolio, the same investor has 50 positions for 100 USD each. It means that each claim effectively represents 2% of the whole portfolio.

The minimum position size of the position matters because of the diversification floor that requires consideration. If the minimum for one claim is 100 USD, the investor can only have a maximum of 5 different positions inside a 500 USD portfolio.

How many loans do I need to be diversified?

There is no universal number of how many loans the investor needs to have a diversified portfolio, as the goals for diversification and the assets inside the portfolio differ on a case-by-case basis. Some investors may prefer to attribute a larger amount of capital to projects with a lower risk profile and increase their exposure to the particular borrower to a hypothetical 10% from 5%. The others, on the other hand, may prefer allocating less capital to every position while purchasing more. So, they can prefer 50 positions for 100 USD inside a 5,000 USD portfolio.

Concentration Scenarios: What One Default Actually Costs

Different scenarios of hypothetical portfolio diversification presented in the table below provide an illustrative overview of the costs of one default inside the portfolios with a different composition.

This figure is an arithmetic illustration using hypothetical allocations and a 100 USD minimum, not a forecast of returns or losses. The actual number of loans available for diversification is limited by the projects on the platform.

Diversifying Across Credit Rating, Term, and Collateral Type

Diversification spreads exposure across borrowers; it does not eliminate the credit risk of the asset class, and returns on 8lends remain unguaranteed regardless of how many loans an investor holds.

The number of borrowers in the portfolio is only one aspect of diversification. The investor also has to access a wide range of other factors to increase diversification, including the following: diversification by a more complete approach. Other factors important for the diversification include:

1) Platform’s credit rating from AAA–D. A higher score means that the borrower is considered to be less risk-prone.

2) Loan-to-Value (LTV) ratio of the collateral calculated by a formula: LTV = (Loan / Collateral) * 100. A ratio below 100% means the complete coverage of the loan value with the price of the collateral, while a higher value means that some parts of the loan remain unsecured.

3) Collateral type and valuation. Different types of collateral, like operational business assets, real estate, and vehicles, all have different liquidity and risk profiles.

4) The term of the loan. A loan that reaches maturity in 4 months is drastically different from the loan that will reach maturity in 16 months.

5) BuyB status. A BuyB badge on 8lends identifies the projects that are eligible for buyback protection in case of the borrower’s prolonged delinquency of more than 60 days. Does not guarantee repayment and should be considered as an additional layer of security.

6) The industry of the borrower. Different companies operating in different sectors carry industry-specific risks.

7) Pool closing date. If the project needs more time to reach its financing goal, the date of the first interest payment may change.

Should I diversify by credit rating or by term?

It is advisable to diversify using both the credit rating and the loan’s term because these variables address different aspects of risk management. Credit rating is connected to the assessment of the borrower’s creditworthiness and the ability to repay the debt. The term of the loan affects how long the principal will be held and how the interest will be distributed to the investor.

Reinvesting Monthly Interest Without Concentrating Further

Diversification of the portfolio changes based on the time. Interest is tied to the loan term and is paid monthly in full installments, whereas the principal is typically returned to the lender upon the claim’s maturity. The first interest payment is paid to the investor after one month of the loan being active.

When the lender is repaid the principal, they may decide to reinvest it in the other projects. In this case, the investor may choose different projects and allocate the funds again. It is important to consider all the aspects above to make a weighted decision about the diversification of the portfolio, and potential reinvestment. The same aspects are important for reinvestment too.

Can I reinvest interest automatically?

No, the investor cannot currently reinvest interest automatically. 8lends has the plans for developing an automatic reinvestment option, but it is still not present on the platform. That is why the investor needs to manually decide where they would like to reinvest the money.

What Diversification Does Not Fix

Diversification has certain limits and does not fix the credit risk of the individual borrower. They may go bankrupt due to external market conditions, some operational failure, or unexpected operational circumstances that carry a profound effect on the whole operational chain. Since there is no possibility of definitely predicting every scenario, diversification is not a guarantee against the borrower’s default.

Likewise, diversification does not eliminate platform-related risk. 8lends operates with the independent partners, Alpha Systems LLC which supports 8lends as a VASP under FSA SVG supervision, and Maclear AG acts as an independent Collateral Agent and a member of PolyReg SRO, a self-regulatory organisation recognised by FINMA. However, the separation of the operational functions does not remove the risk of the platform’s technical difficulties or the insolvency of a counterparty.

A buyback mechanism is not equal to a guarantee of repayment either. The investor may try to mitigate the borrower's default risk by choosing multiple projects with a BuyB badge on 8lends to potentially be eligible for the loan being repurchased by the originator under certain conditions. However, even if these conditions are met, the originator may experience difficulties and be unable to execute the operation. This is why BuyB projects are not a guarantee of repayment either.

Liquidity is another limitation, as crowdlending positions typically fluctuate between 4 months and 16 months. If the investor purchases more claims with a different timeframe, they are still not typically entitled to exit earlier. Early exit is limited to the Secondary Market where the investor may try to find a buyer who will purchase the claim they want to sell. However, the sale is not guaranteed.

Finally, the natural limit is the projects that are available on the platform at any given time. The investor who purchases claims on 8lends cannot purchase any project they would like to, as the pool of the projects currently available for financing is limited.