FAQ Corner: What do the platforms mean by “diversification”?

The alternative finance space can loom as rather daunting to first-time investors. But in truth the concepts are reasonably simple, if only one can sift their way through the jargon.

“Diversification” is not a term owned by the world of alternative finance – but it does occupy an important position within that world. And although the term “diversification” sounds relatively self-explanatory, and means broadly the same thing in whichever market it is applied, it warrants a more in-depth level of understanding when used in relation to alternative finance platforms.

Without exception, alternative finance providers will advise their investors to seek to achieve diversification. In layman’s terms, that means that investors ought to strive to spread their money across multiple deals, spanning various industries, risk-bands, levels of security, geographies and so on. A lack of proper diversification means that investors are likely to be too heavily exposed to a small number of investments. If an investor spreads £100k evenly across four deals, and one goes wrong, the investor is in trouble. If that investor spreads the £100k evenly across a hundred deals, there’s greater room for error. Three or four deals could go wrong, and the investor might still be earning a positive return.

The strategy (spreading risk) is simple. Effecting the strategy, however, varies platform to platform, sector to sector, and can also be achieved through the use of intermediaries.

Equity crowdfunding

Let’s start with equity crowdfunding, since that’s probably the easiest to understand. All of the big UK platforms follow the same blueprint; they allow you to handpick the startups that you wish to invest in. That mechanism of investing means that the onus is on you, the investor, to take responsibility for creating a balanced and diversified portfolio of startup investments.

To achieve diversification passively in the equity crowdfunding space, a sole solution springs to mind. Strathay Ventures currently runs a “Venture Fund” on the Seedrs platform. Investors may participate in the fund in order to gain exposure to a tailor-made portfolio of ten different early stage businesses.

Of course, diversification in general is a different beast in equity crowdfunding. You’re not so much diversifying in order to limit the impact of potential losses, as much as you are diversifying in the hope of finding some winners.

Peer-to-peer lending

There’s much more to consider on the subject of diversification in P2P lending. There are some platforms upon which investors will again need to actively diversify, by hand selecting the loans to which they will allocate funds. Funding Circle, the world’s largest peer-to-business lender, is one such platform. The company is constantly at pains to urge its investors to ensure that they are sufficiently well diversified. The platform suggests trying to achieve a spread of at least a hundred different SME borrowers.

For the likes of Zopa and RateSetter-like outfits, diversification is taken care of by the platforms themselves. You allocate funds to the platform, and the platform then decides to whom your money will be lent. Your money will likely be spread across a large number of deals.

Should the platform employ a provision fund coverage model, it isn’t as essential that they diversify on your behalf. Lenders will be made whole by the provision fund in the instance of an underlying default, so diversification is still important, but not as important.

The type of P2P site that you’re lending to is also a factor. Some self-selection platforms, like Assetz Capital, specialise in larger deals than the likes of Funding Circle. So whilst you still have to ensure that you’re investing in a decent spread of businesses, there simply won’t be as much deal flow as is provided by the likes of Funding Circle. The crucial difference is that all Assetz loans are secured against an asset (as the name would suggest), such as property. So you might only hold twenty loans on Assetz, as opposed to a hundred unsecured loans on Funding Circle, but diversification is your only defence in the latter instance; diversification and realisable security have you covered in the first instance.

Methods of access

There are a number of other modes of achieving diversification. Intermediaries. Companies that have inserted themselves between you, the investor, and the platform, which originates the deals. By investing in such a company, you no longer hold a direct relationship with the borrower (/fundraiser) when investing. And that extra degree of separation comes at a cost.

So why would you bother? It really boils down to two factors: convenience and outperformance.

The most pertinent examples of intermediation in the alternative finance space are the fast-proliferating fund structures. These funds purchase whole loan assets from the platforms and package them up into an equity product. Take P2PGI, for instance. You invest your money into the fund by purchasing shares. You no longer need to be concerned with diversification, because P2PGI takes responsibility for the deployment of your money. In that sense, it’s a more convenient method of investing. It can also be a more profitable method of investment, in that P2PGI claim to possess the necessary resources for identifying and purchasing loans which top the average yields of a given platform.

The aggregators – the InvestUps and Business Agents of the world – are different. These facilities pool investment opportunities from a host of different platforms into one, centralised resource. But the onus is still on you, the investor, to ensure that you’re money isn’t overly concentrated. Aggregators make the task of cross-platform diversification easier, because they enable access to a broader range of deals, all from within a single portal.