Alternatives In Focus: Alternative Lending – Q1 2018 Newsletter

We started using the Stone Ridge Alternative Lending fund (LENDX) roughly a year and a half ago. It has returned around 6% annualized since we started investing, which is in-line with our long-term expectations for alternative investments. That return looks all the more attractive when you consider that the bond market earned only 3.5% last year.

In fact, LENDX is a bond fund of sorts. However, instead of buying debt issued by government entities or large corporations, the fund buys loans made to small-scale borrowers. These may be student loans, personal loans, or business loans, and they originate on one of several major on-line lending platforms, such as Lending Club, SoFi, Square, and others.

The borrowers on these loans have a very solid credit profile. Their average income is over six figures, the average FICO score is above 700, and the average business loan is to entities that have been in business for 12 years and have over $2 million in revenue. However, the average size of a loan in the fund is just below $20,000.

Importantly, the duration of the average loan is 1.4 years. This compares with a duration of 6.2 years for the overall U.S. bond market. What that means is that traditional bonds are much more sensitive to interest rate moves than LENDX. Duration measures the approximate amount of money you would lose (gain) if interest rates were to rise (fall) by 1%. So, for every 1% move the Fed makes to short-term interest rates, you could expect about a 1.4% reduction in the principal value of LENDX. This would be offset by its yield, so the total return would likely still be positive. For more traditional bonds, you could expect a 6.2% drop in value as interest rates rise, and their yield is not high enough to offset that price drop.

The other interesting component to a short duration fund is that as interest rates rise, the lending platforms will charge higher interest rates on new loans. Because the existing loan portfolio is so short, it won’t take long for the new higher rates to be reflected in the fund in a meaningful way. So, rising interest rates could actually be a positive for LENDX.

The best part about the fund is that its returns are largely independent of the stock market’s returns. A large spike in unemployment could result in lower returns, as borrowers are unable to repay their loans, but in more normal environments, fluctuations in other parts of the capital markets should not impact the returns of LENDX.

In fact, while the fund was not around during the financial crisis of 2008, some reasonable modeling suggests that this type of approach would not have lost money that year. Returns certainly would have been below the 6% we have enjoyed so far, but not necessarily negative.

Any investment that reaches for respectable returns over time will also pose risk. This fund is no different, but we believe the diversified nature of the fund, a solid management approach, reasonable leverage, and a strong approach to credit checking make the fund a good trade off between risk and return. Currently, the fund manages over $3 billion.

If you would like to talk further about this fund, or any other investment in your portfolio, feel free to reach out to us anytime.

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