Diversification and returns in a COVID-19 period

 

For investors COVID-19 have created a huge challenge with high volatility in the markets and central banks that is buying almost unlimited amount of government bonds in order to stabilise those financial markets that otherwise would be flooded with bonds. This gives stability short-term, but what will be expected over the coming 5 years investment horizon.

 

Alternative lending – Quantrom expected returns

Based upon more than 3 years of track record including the turbulent last six months with COVID-19, our expectation is that loan originators with a good process and credit model will not have problems navigating this difficult economic situation. As seen from the chart below, alternative lending with collateral and/or buy back guarantee are not having problems beyond what could be expected.

Figure 1 Performance under COVID-19 in different alternative lending classes

Pay day loans are at the moment performing badly, but will not impact Quantrom P2P Lending since we never have invested in such loans as seen from above. Furthermore, in many countries rates on such types of short-term consumer lending are being capped making this business model unviable.

Our expectations are that Quantrom P2P Lending also over the coming 5 years will be able to generate an annual return of more than 5% (long-term return target) with a standard deviation around 2.5% over the coming 5 years.

Expected returns in other asset classes the coming 5 years

The Danish Return Council (“Rådet for Afkastforventinger”) that makes forecast on investment returns, that pensions funds and banks can use towards their clients, has updated their predictions in June 2020. That are indeed very interesting projections.

Figure 2 Danish Return Councils 5 years return forecast combined with Quantroms own forecast

Government and Mortgage bonds are expected to offer a negative return of 0.3% per year over the coming 5 years, while investment grade bonds after all will have a positive return of 1.1% and property investments are expected to return around 2.8% yearly. Investment with relatively low standard deviation will mainly return around or less than the expected inflation rate.

Higher returns can be expected with higher standard deviation when moving into global equities and high yields bonds (an asset class that is highly correlated with equity prices). However, since the Council made their prediction based on figures from end of March, the equity markets have gained between 20% and 30% already equal to 4-5 years expected return in just 4 months. It is difficult to imagine that this will continue over the coming 5 years.

Private equity is expected to offer a high return but it is also the investment with the highest standard deviation and thereby risk. Furthermore, private equity investments are rarely available to private investors.

Diversification towards the real economy, cash-flow, and geographical region.

Given these forecasts, Alternative lending is an asset classes that will offer investors one of the highest annual returns with one of the smallest standard deviations. A very attractive proposition for investors that would like a diversified portfolio.

With the divergence between financial and real economy, alternative lending offers an opportunity to buy exposure towards the real economy.

Furthermore, alternative lending also offers the possibility to get exposure towards other countries than traditional Western EU member states, that are covered with different financial instruments, by investing in countries such as Estonia, Latvia and Lithuania. With the additional advantage that the exposure is still in EUR and inside the European Union.

An investment in Eastern EU countries is also an investment in countries that have the best underlying macro-economic fundamentals and thereby the best chance to get out COVID-19 recession quickly and with a less adverse impact on GDP.

Last but not least alternative lending is cash-flow based which implies that there are monthly payments of interest and principal. As always, a steady and stable cash-flow has never hurt an investor.

 

About the Author

Gustav Jensen

Gustav is the managing director of Quantrom Limited and is living in near Brussels.

Economist from University of Copenhagen mainly working in finance and banking.