By Rupert Taylor on Wednesday 25 March 2015
Here at AltFi Data we have been extremely excited to launch the first comprehensive industry returns index – the Liberum AltFi Returns Index or LARI. Inevitably, now that investors can discern what the industry has returned since its inception in 2006, they now want to know to what they can compare these returns. Having had the opportunity to give this some thought we wanted to highlight our conclusions.
Figure 1: The Liberum AltFi Returns Index from inception to date.
Before we get to possible comparators let us remind ourselves what the LARI is. The LARI is a time weighted index constructed using the cash-flows of every loan made by an eligible platform since inception. By constructing the index from every cash flow an accurate return is calculated which is effectively the gross lending rate, net of fees, net of defaults, and after adding back any recoveries. The index is represented as a twelve month trailing return. This return can be viewed as a yield. For readers interested in learning more about the index calculation, the full methodology can be downloaded here.
It is critical at this stage to recognise that this index does not include any price component. i.e. all loans are valued at par unless they default. If loans default, the LARI calculation values them at zero until such a time as the cash flow from any recovery can be reflected. In all aspects the index seeks to replicate, as accurately as possible, the investor experience. As such, the absence of a price component reflects the reality that, at present, these assets are hold-to-maturity assets with little in the way of actively traded prices. Whilst some platforms do offer secondary liquidity there is not sufficient activity, in our view, to extract any meaningful price information. Almost all loans therefore redeem at par, unless they default, so to include a price component, when realisations are rare and secondary markets illiquid, would at best add little and at worst be misleading.
When considering comparators it is therefore crucial to recognise that there is no ‘price’ component to the LARI. The LARI accurately represents the investor experience of these hold-to-maturity assets by measuring the return available, which is almost exclusively yield. However many oft quoted indices contain a ‘price’ component. Indices such as the FTSE 100, or the S&P500 are, in industry parlance, total return indices. That is to say the index return is made up of both a price return and an income (yield) return. These indices are therefore likely to be much more volatile simply because the price component will be continually adjusting to changes in the environment as interpreted by market participants. As a result a comparison of the LARI with any total return index is largely spurious.
Here at AltFi we therefore believe that comparisons with total return indices are misleading. We favour comparisons with:
Two such assets are:
Figure 2: The Liberum AltFi Returns Index plotted against a composite of leading UK Money Market Funds and the average UK Bank 2yr term deposit rate.
A comparison with the former is simple. One simply has to choose a term deposit index of a comparable term and it provides valuable context. A term deposit is very low risk, almost certainly lower risk than P2P assets, and offers a superior return to cash as a function of the period of time for which capital is tied up. Perhaps unsurprisingly P2P offers superior returns to UK 2yr term deposits.
Money market funds are an equally worthwhile comparison. There is no price component, and absent a period of unprecedented financial market dislocation as occurred in 2007/8, they can always be redeemed at NAV, which should always represent at least $1, i.e. effectively par. The problem with money market funds is that there is no widely followed actively quoted index. However, in the interests of making the comparison, we have constructed an index of the ‘top 5’ money market funds. Again P2P offers superior returns, but almost certainly P2P comes with higher risk.
The obvious issue with this comparison is that due to the higher risk that P2P investments incur, they also offer higher returns than these comparators. It is very tempting therefore to compare the LARI to something further up the fixed income risk spectrum - a High Yield Index or a Leveraged Loan Index for example. The problem here though is that these indices are total return indices. So until such a time as there is a meaningful price component we are inclined to avoid such comparisons. For illustration purposes however I attach such a chart below. Note the period over 2008 where these bonds traded materially below par and then subsequently re-bounded. The ‘apparent’ stability of P2P by comparison ignores the reality that had the loans been freely traded they may have exhibited similar volatility. We just don’t know – but it is clear to me that whilst such comparisons are interesting they should come with a clear health warning.
Figure 3: The Liberum AltFi Returns Index plotted against S&P's Leveraged Loan Index and Barclays' Global High Yield Index (Both Total Return). Rebased to and index value of 100 on 30/04/05
In considering this concept of comparators we have also hardened our views on some related issues.
The first relates to volatility. There have been some signs of analysts jamming P2P assets into existing risk frameworks in an attempt to quantify the risk. To us such an approach is fraught with danger. Whilst we cannot yet point to our own risk framework, which remains a work in progress, we are already pretty certain as to what we see to be the wrong approach. The immediate problem with this existing approach is twofold. Firstly, even though volatility has consistently proven itself to be a poor measure of risk, analysts and investors persist in using it as their primary yardstick. Here at AltFi we have always argued that risk is not represented by price volatility – the only relevant component is likelihood of a permanent loss of capital. History is littered with examples of assets with low volatility proving to deliver significant losses. Even worse, assets with the lowest volatility going into a period of financial market dislocation have often delivered significantly worse losses than those with higher volatility. Even with the recent dislocations of sub-prime and European sovereign bonds serving as stark reminders of this issue, risk analysis based largely around volatility persists.
But there is a further problem with regard to P2P. The absence of an active secondary market and therefore loan pricing should not be interpreted as a representation of low volatility and therefore a measure of low risk. We were horrified to see last year that an investment website had assigned a risk score to one platform’s loans based solely on the lack of price volatility that it displayed. The ludicrous result gave the platform a risk score of 1. For context, the same site conferred a “risk score” of 10 upon UK Government bonds and the FTSE received a score of 100. This is hazardously misleading and, to our mind, unhelpful. The reality is that the absence of an actively traded market is in itself a risk factor.
The second issue relates to how we should think about an index. Given that the LARI is the first index to accurately represent the returns of a new asset class in readily comparable format, it is inevitable that one of the first reactions of an investor is to see how the return shapes up versus other asset classes. The LARI at last allows us to do that and to recognize that P2P offers a superior return to cash with some added risk. The number it produces is enormously valuable but must be considered in context and the differences in the nature of different asset classes mush be recognized. Just like it is useful to compare the annual return of the FTSE to the yield on UK gilts, it is only a worthwhile exercise if one recognizes the differences between the two sets of assets. Equally one should reflect on the primary purpose of most indices. The S&P 500 can be compared to US treasuries or a US corporate bond index. But it is also a benchmark allowing comparison with directly comparable assets i.e. comparison with its own constituents or comparison with the performance of a fund which may be benchmarked against it.
So lets be clear on what LARI is:
But let us also recognize what it is not:
And whilst we are at it – let’s also recognize that whilst P2P offers impressive returns it is not yet appropriate to attempt to discern the inherent risk by analysing the volatility of the returns. P2P has just celebrated its 10th birthday, but this is still a developing asset class. We hope that LARI represents a step in its development. And we also recognize that liquidity will probably develop over time. When it does, volatility analysis, notwithstanding its inherent flaws, will become a worthwhile exercise. But until it does the absence of liquidity should not be confused with an absence of risk!