Escape From The Matrix: Alternative Finance And Investment Advisors
Escape From The Matrix: Alternative Finance And
at the heart of the investment advisory industry.
Alternative Finance, especially Direct Lending (Peer-to-Peer Lending, Peer-to-Business Lending) can
provide excellent returns, but is largely ignored by investment advisors.
When and why Alternative Finance will be accepted as an important new emerging asset class.
Neo: I don't like the idea that I'm not in control of my life.
Morpheus: I know exactly what you mean. Let me tell you why you're here. You're here because you
know something. What you know you can't explain, but you feel it. You've felt it your entire life, that
there's something wrong with the world. You don't know what it is, but it's there, like a splinter in
your mind, driving you mad. It is this feeling that has brought you to me. Do you know what I'm
Neo: The Matrix.
Something is wrong, very wrong, at the heart of the investment advisory industry.
Many of my most astute colleagues, who like your author have more than two decades of experience
in private banking advising high net-worth clients, know in their hearts that something has gone
awry in our trade. Far from improving, the situation is worsening, and the very tools of our
profession (deposits, stocks, bonds, annuities) are increasingly inadequate to build a portfolio for our
clients that will satisfy their fundamental needs for capital preservation plus reasonable, low
volatility growth over time.
Like Neo in "The Matrix", we face a choice. We can take the blue pill and ignore these doubts about
our current toolkit. We can take comfort in empty concepts such as "stocks for the long term", "buy
and hold", or "value at a reasonable price" or the misleading "value at risk" methodology. We can
continue on our merry way, hoping that things will work out eventually, despite the increasing body
of evidence to the contrary.
Alternatively, we can choose to take the red pill, admit that we need to free our mind of outdated
concepts in order to find better tools and methods to serve our clients, and get to work to find
solutions. This article is written to motivate investment advisors to have the courage to take the red
pill and embrace Alternative Finance for the benefit of their clients.
Investors, or Savers?
One of the fallacies that has enslaved the minds of investment advisors is the idea that their clients
are "investors". My experience is that this is patently false. Warren Buffett is an investor, George
Soros is an investor, but most of our clients are in fact simply savers, even if they can correctly be
profiled as "sophisticated investors" and hold substantial wealth. They hold for one reason or
another an accumulation of financial wealth that is not needed to finance their living expenses in the
short or medium term (though it may well be needed for retirement) and seek to earn a reasonable
return on this money. A "reasonable return" for most would a few percentage points above the
current inflation rate in their base currency, but crucially with a primary emphasis on capital
Most clients would be perfectly satisfied to earn this sought-after return on their capital through
bank deposits, and have done precisely this until very recent years. Here the bank serves its classic
function of paying a reasonable interest rate to take deposits from those who have a surplus of
money, and charging a somewhat higher interest on loans issued to qualified borrowers who have a
deficit of money during a given time period. This is a win-win situation, as the savers earn a return
on their hard earned savings, while the bank serves as an intermediary to allocate this surplus
capital to consumers and business people to enable them to finance their purchases or investments
to grow their businesses.
Bank Deposits No Longer an Attractive Investment
In recent years, this model, so essential to our economy, has to a large degree ceased to function.
Central banks throughout the developed world have pushed interest rates to historic minimums
hoping to stimulate sluggish economies and lower chronic high unemployment rates. Returns from
bank deposits both in the US and Europe are now rarely above 1% per annum. The lost interest
income to those who save through bank deposits has made a dramatic impact in any reasonable
estimate of the amount of money necessary to provide sufficient income for a secure retirement. The
official and lasting policy of low interest rates in the developed countries has forced many savers to
move from the security of the government-insured bank deposits to assume a much greater risk as
investors in the capital markets in order to attempt to earn an acceptable return on their savings.
Bond (and Annuity) Yields at Record Lows
A further problem for our clients today, both savers with bank deposits and investors in the capital
markets, is the extremely low returns offered not only by bank deposits, but also by fixed income
instruments, due to the consequences of quantitative easing. Simply stated, quantitative easing has
distorted price signals of all kinds, not only for government bonds, but also for corporate bonds and
shares. As central banks have purchased government securities in massive quantities in recent
years, interest rates on all fixed income instruments have been driven down to historically low
levels. At the same time, stock prices have risen to lofty new highs due to the increase in margin
lending, and low bond yields have driven money into the stock markets in search of returns even at
the expense of far greater risk. Fixed income yields have been driven down even further as banks
have joined the central banks as major buyers of government bonds in recent years. When banks buy
government bonds of their home country they not only do a favor for the political leaders seeking to
finance the government deficit as cheaply as possible, but also earn a zero risk return as they deploy
their depositors' capital in a way favoured under the new banking regulation rules of Basel III.
Unknown Risks: The Real Problems for Savers entering the Investment Markets
To return to our starting point, what is wrong at the heart of the investment advisory industry today?
The answer is the overwhelming prevalence of totally unforeseen and unknown risk which should
never be assumed by clients who value preservation of capital before any other consideration.
Savers who leave the shelter of deposits in the banking system to seek higher returns through
investment in stocks or bonds are faced with a gamut of risks that can be neither fully disclosed nor
mitigated by their investment advisor. This is because these risks are simply unknown and arise
from totally unexpected quarters as the investment markets for bonds and shares are impacted by
events around the world. In my career as an investment advisor I have seen "once in a century"
events taking place in the financial markets at least four times, originating in such unexpected
places as Russia in 1998 or American mortgage-backed securities in 2007. Furthermore, comforting
concepts such as Value at Risk are a fallacy, as they are based on the assumption that the
distribution of investment returns over time follows a normal bell curve. This is not the case, as
extreme events with profoundly negative consequences for the stock and bond markets occur with
much greater frequency than is indicated by the models. In short, risk for substantial loss of capital
in the stock or bond markets exists at all times, and for this reason these markets do not satisfy the
needs of the vast majority of savers whose primary objective is capital preservation, even while
seeking a reasonable return on their capital.
The Rise of Alternative Finance, Direct Lending and Bank Disintermediation
Even as banks fail to offer attractive rates for savers, they also are unable to provide many of their
clients with affordable consumer and small business loans due to the enduring consequences of the
recent global financial crisis. New banking regulations, both through new domestic laws as well as
the more stringent international banking reserves requirements of Basel III have caused banks to
pull back from lending activities to all but the largest and most solvent borrowers. Consumer loans,
small business loans, trade finance loans, real estate loans, in fact, loans of all categories normally
financed through the banking system have been curtailed or even eliminated by many banks as they
have reacted to the combined impact of new banking regulations and Basel III by refocusing their
business on only their largest corporate clients.
In short, the current situation is one where savers are unable to obtain reasonable returns neither
from safe bank deposits nor from much more risky investments in the fixed income markets. At the
same time, those who need financing, consumers and businesses, are often unable to obtain loans
from these same banks. This situation, combined with the ability of internet based platforms to
efficiently and directly bring together savers and borrowers, has given rise in recent years to an
entire new industry outside of the banking system, which allocates capital without the
intermediation of banks.
Direct lending allows savers to obtain a return on their capital far superior to that offered by bank
deposits, fixed income investments in the capital markets, or from dividend-paying shares in the
much riskier stock market. In the United States and Great Britain especially, there are now dozens
of consolidated platforms with multi-year track records of successful operation, providing funding to
consumers and small and medium sized businesses. Through disintermediation and operating
without the legacy costs and suffocating bureaucracy of the banks, these efficient platforms are
profitable while charging only a small fee for their services of selecting qualified borrowers and
maintaining a transparent and smoothly functioning marketplace between savers and borrowers.
The result is that savers gain a return on their capital that reflects the true value of their money over
time, as well as being far superior to the current extremely low interest rates from bank deposits
and investment grade bonds.
Whether known as Peer to Peer Lending (P2P), Peer to Business Lending (P2B), Direct Lending,
Crowdlending or the more general term "Alternative Finance", this new industry is growing at an
exponential rate and has huge implications for the asset management industry in the medium and
long term. Judging by the recent explosion in media coverage, Peer to Peer (P2P) lending seems to
be approaching a tipping point where it will move out from its current base of early adopters, and
into the mainstream of the investing (and borrowing) public. From my perspective as an investment
advisor in Madrid, Spain, I see new P2P platforms sprouting like mushrooms after a spring rain
throughout the United States and Europe. These newcomers will accompany and compete with the
established market leader Lending Club and the number-two-but-trying-harder Prosper.
Those who might think that P2P lending is too insignificant to merit serious consideration at this
time should consider the fact that the two leading firms, Lending Club and Prosper, are experiencing
exponential growth and together have managed already over 5 billion dollars of loans paying out
many hundreds of millions of dollars of interest to savers. In 2013 Lending Club received the
ultimate vote of technological confidence when Google (GOOG) took a $125 million stake in the
company, valuing Lending Club at $1.55 billion, fully three times its value at the previous fund
raising a year earlier (see Dara Albright's article, "How Google's Investment Into P2P Lending Will
Impact The Financial Markets"). A Lending Club IPO is widely expected for later this year, with
valuations over $5 billion commonly offered by analysts.
The Board of Director of Lending Club includes such luminaries as former Visa Inc. (V) President
Hans Morris; the former U.S. Secretary of the Treasury Lawrence H. Summers; Morgan Stanley
(MS) Chairman Emeritus John Mack and Kleiner Perkins Caufield & Byers General Partner Mary
Meeker. Not to be left behind, in January of 2013 Prosper put into place a new management team
backed by Sequoia Capital, and since then the Prosper platform has posted accelerating growth in
The rate of return available to savers varies from platform to platform, depending upon the loan type
and quality, the financial strength of the borrower and whether the loan has recourse to other assets
in case of non-payment. Several years of available data demonstrate that the real return available for
savers from a well-diversified portfolio of direct loans is typically in the range of 5% to 10% per
annum, even after taking into account defaults from lenders who fail to repay their loans. This range
seems unduly generous only in the light of the exceptionally low interest rates of recent years
resulting from the distortions introduced by actions of the central banks. In fact, 5% to 10% per
annum represents nothing more than the historical true value of money under normal
circumstances. This range is also what those who need to take a loan for consumer or business
purposes are gladly willing to pay, or are already paying to their banks when financing is available,
and often much more.
For further information from very credible sources, be sure to see the article by Zach Miller, "Why
I'm A Converted Believer In Investing in P2P Loans" as well as the excellent resources available at
www.lendacademy.com by Peter Renton, a pioneering figure and noted authority on P2P lending.
Where are the Alternative Finance Investment Advisors?
Given that these attractive returns are available through direct lending in the new alternative
finance space, why do investment advisors rarely if ever recommend direct lending to their clients?
Why do they remain trapped in the current matrix of inadequate tools to build portfolios for their
investors? Firstly, most investment advisors have yet to learn of the very attractive opportunities for
their clients presented by direct lending as they continue to focus on what they already know, which
is basically deposits, bonds and shares. Secondly, the vast majority of investment advisors in fact are
not independent, but rather work for banks and investment advisory firms that are perfectly satisfied
with the status quo, which is profitable for banks, asset management firms and advisors, even if this
is not the case for the clients. Finally, until very recently, participation in alternative finance
required that the client directly open an account in one or more of the online platforms and manage
their loan portfolio personally. While this is adequate for many people, it is not an attractive option
for those who do not want to personally dedicate substantial amounts of time to follow their
investments online. Managed accounts in existing platforms, alternative finance focused mutual
funds and ETFs are the solution for these clients. These instruments will become increasingly
available in coming months both in the US where numerous P2P lending funds are already available
for accredited investors, as well as in Europe, where Synthesis has offered since 2012 the first
specialized peer-to-peer lending fund launched and regulated in the European Union.
World of Efficient Capital Allocation between Savers and Borrowers
It is time for investment advisors to take the red pill, break free of The Matrix (and in too many
cases conflicts of interest between the needs of their employers and the needs of their clients) in
order to guide their clients to the new asset class of direct lending. It is here where investors can
earn reasonable returns on their capital while assuming only a single, quantifiable risk, that is,
credit risk. Unlike the host of unforeseen risks that face investors in the interconnected and fully
globalized stock and bond markets, credit risk for savers in alternative lending can be accurately
measured, and can be mitigated through broad diversification and careful selection of borrowers.
A new investment horizon, one beyond the constraints of the current investment advisory matrix, is
becoming visible, where our clients can earn reliable and worthwhile interest rates through
participating directly in the real economy, bypassing the banks, with a mix of alternative finance
investments including Peer-to-Peer (P2P) loans, Peer-to-Business (P2B) loans, factoring/discounted
invoice-based loans, trade finance loans and mortgage-backed lending, just to name a few
categories. These clients will not only benefit by earning higher and more reliable returns on their
capital, but will also have the satisfaction of knowing that their savings are serving to benefit the
real economy through funding consumers and businesses. The success of their investment strategy
will depend almost exclusively on the control and mitigation of credit risk and will be independent of
the market gyrations resulting from the impossibly complex interactions between economic growth
forecasts, projections from investment banks, proclamations from the central banks and purchase
and sales by hedge funds and high frequency traders that determine returns in current stock and
A rebellion has begun against the current comfortable status quo which serves the needs of banks
and investment advisory firms to generate fees and governments to secure low cost deficit financing,
but fails to satisfy the basic needs of our clients. The time is now to escape from The Matrix and
begin to bring the benefits of the direct lending/alternative finance revolution to our clients through
accepting this new asset class into the standard toolkit of the investment advisory industry.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within
the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving
compensation for it (other than from Seeking Alpha). I have no business relationship with any
company whose stock is mentioned in this article. (More...)