There has been quite a bit of activity lately for one of our alternative funds, the Stone Ridge Alternative Lending Risk Premium Fund (LENDX), and we thought it would make sense to provide an update.
LENDX buys small consumer, business, and student loans. It does this through on-line lending platforms like Lending Club, Square, Sofi, and others. These loans are made to high quality borrowers with average FICO scores above 700. The interest rates on these loans are relatively high, as they are generally too small to be of interest to traditional lenders, such as banks.
This creates an opportunity for investors to earn higher returns than with traditional bonds, but with different risk characteristics. For example, while a spike in unemployment could result in delinquencies for LENDX loans, the fund has very little sensitivity to interest rates, unlike traditional bonds. This makes LENDX an interesting portfolio diversifier when used as a component of a more traditional stock/bond portfolio.
While the fund generally invests only in loans, it recently found itself with a couple of stock holdings. Because LENDX buys loans from its partner platforms in such large size, it is often able to negotiate better terms than other investors. These benefits typically amount to higher interest rates or lower platform fees. Notably, in a couple of cases it has meant taking an equity position in the platforms themselves when they were still private companies. This was true for the SoFi platform and the Upstart Holdings platform.
Recently, both SoFi and Upstart Holdings filed IPOs. Their stocks have performed quite well, creating a windfall for LENDX. Generally, the fund has earned returns of around 6% per year, but because of its stock holdings, it has returned almost 40% over the past year. While this is unlikely to repeat in the future, we still believe the fund is attractive because of its core loan buying strategy.
The excess returns this year have certainly been welcome, but they have also created some confusion. When LENDX sold the stock positions, it realized a substantial capital gain. Mutual funds are required to pay out their realized capital gains to shareholders each year. So, LENDX did a special distribution that amounted to a 21% “dividend” just before the end of the second quarter. When a fund or stock pays a dividend or capital gains distribution, its share price drops by the amount of the distribution. This makes sense since cash held by the fund gets returned to shareholders, making the shares worth less. However, while the share price drops, the return earned by the fund is still quite high since dividends and capital gains are components of total return.