Funding Circle Investment Fund. No Charge!
A leak to the Financial Times has revealed that Funding Circle* is planning to be the first P2P lending website to create its own investment fund – and it's got some very interesting features, so pay attention.
It's called the Funding Circle SME Income Fund. Here's what we know of the deal so far and my opinion on it:
How the fund works
According to the leak, the fund is likely to start at around £150 million.
This means that, once Funding Circle has managed to lend out all that money, you'll be lending to hundreds – possibly thousands – of credit-checked businesses through the fund.
Instantly spreading your money across so many borrowers will greatly lower your risks.
The fund will buy slices of its loans on its UK and US websites, and from any other country that Funding Circle sets up in.
We don't yet know how it will be balanced and rebalanced across different countries as new loans are listed. But it's a passive fund, which means that it'll buy up lots of Funding Circle loans automatically and it won't be actively managed for outperformance.
Funding Circle is hoping for returns between 6% and 7%. This is precisely in line with the amount that UK lenders have earned through Funding Circle so far, on average, after costs and bad debts.
No fund fees!
I've never heard of this before, but the fund will charge no management or performance fees whatsoever.
Presumably this is because it would mean doubling up on its fees: fundholders would have to pay both the fund fees as well as the normal costs for lending their money through the website.
You should still expect to face some additional costs, since Funding Circle will be allowed to pay for certain expenses from the proceeds of the fund. This will decrease the overall return.
However, in the case of this fund I would expect these costs to be very minimal.
You will also have to pay fees to your broker, pension provider or ISA provider for buying and selling the fund, and potentially annual admin fees as well.
How this fund compares
Currently, there are independent funds that invest across many P2P lending websites.
These existing funds have often focused on investing in the P2P lending websites themselves, meaning the fund itself buys shares and becomes a co-owner in them.
However, they have also been lending directly to borrowers through these P2P lending websites in the same way that you and I do and this will probably increase now due to new legislation that has already come into effect.
These independent funds charge their own management and performance fees on top of the fees charged by the P2P lending websites for lending through them.
If you've read a book or two on investing you should know that these costs seriously – seriously! – add up.
You can read more about them and their costs in The Cost Of P2P Lending Funds.
Lend directly or use the Funding Circle SME Income Fund?
If you want very widespread diversification in Funding Circle's loans, the best way to get it will be through the Funding Circle SME Income Fund.
On the flipside, an investment fund means no setting interest rates yourself and no deciding which borrower grades to lend to.
So if you want to limit your lending to the lowest-risk borrowers – and still get a projected return after bad debts of between 6% and 7% – then you would lend directly through Funding Circle.
You can do that effortlessly using Funding Circle's autobid feature. You'll end up lending in maybe 100-200 loans instead of 1,000+, but that is still a very good spread.
Using this investment fund means that you could also benefit from lower taxes sooner through ISAs, but note that lending tax breaks and ISAs for direct P2P lending are coming from April 2016.
I can see two additional risks with this fund over lending directly. The first is currency risk.
Funding Circle's US branch, and other branches that it will open over the next few years, will shortly be lending far more money than the UK branch. As more money shifts overseas you could see the value of your fund holding fall or rise due to moving exchange rates.
Share-price risk – and opportunity
The other additional risk is because this fund (like all P2P lending funds so far) is structured as an “investment trust”.
Investment trusts are funds listed on the stock market, which means you become a fundholder by buying shares in the fund, just like you buy shares in BT, Tesco – or perhaps a company with a better reputation these days.
The problem with buying the funds' shares is that the price of the shares will fluctuate like all shares do.
Say the starting price is £1 per share. The price might fall to 90 pence per share, which effectively means that, for each £1 of loans the fund makes, you're only paying 90p. Awesome. Funding Circle currently won't allow you to buy loans at such a large discount if you buy through its website.
But the price might also be £1.10 when you want to join. This means that you'll have to pay more than the loans are worth. You might still choose to do it, but it will mean you effectively earn a lower interest rate.
If you're earning 7% interest when you buy at £1, you're effectively earning closer to 6% if you buy at £1.10.
Share prices can fall
You also have the risk that the price falls when you sell. The higher the price, the greater the risk of a fall. But no matter what price you buy at – be it 90p, £1, £1.10 or something else – the price can always fall when you want to quit the fund.
One way to deal with share-price fluctuations is to commit to investing a set amount of money regularly, each month, and for a great many years. This means you buy more shares with your money in months when the price has fallen and fewer when it has risen.
This could also help reduce currency risks.
Buy in from the start
An alternative solution is to try to buy in at launch, when you should be able to buy “at par” – £1 will equate to £1 of lending, more or less.
It's not till the fund is launched that the price starts fluctuating on the stock market – which is a secondary market for shares after a launch.
Don't worry if you can't decide to buy shares in the fund in time for the launch. Funding Circle* will no doubt issue more shares to grow the fund at later dates, and you'll likely be given the opportunity to buy “at par” again.
Whether you go direct or buy through funds, you need to pay attention that Funding Circle is not lowering its standards. (That applies for all P2P lending websites.)
In the case of Funding Circle, since you'll be lending across all borrower grades, this will include watching that:
- The borrower mix doesn't shift dramatically to lending to more borrowers in riskier borrower grades.
- Interest rates stay high enough for the risks.
- Late payments and bad debts don't rise out of line with other business lenders or out of line with the performance of the economy as a whole.
- Declared borrower selection standards are not weakened.
More: As usual, 4thWay® will keep you informed about any warning signs through its Alerts Service, which you can sign up to below.
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