In our previous blog we gave an overview of the emergence of marketplace lending within a the Alternative Credit asset class. A large part of the growth in the industry has been the publication of loan performance data to allow investors to independently verify and assess historical returns. In this article we will discuss how portfolio managers approach the risks of portfolio construction and what our analysis of Prosper Marketplace past performance teaches us about the benefits of diversification in a portfolio of prime consumer loans.
1) How do I replicate the platform’s returns?
After a review of historical returns data (available at CreditSCRIPT.com for active platforms), our first concern is how to replicate the platforms historical returns? The risk is of course that our own portfolio might underperform the benchmark as a result of adverse selection of loans. So generally the question becomes how to replicate the benchmark portfolio return? The answer as you would expect is diversification. To mitigate the effects of this portfolio variance, diversification of the portfolio in terms of the number of loans held is critical, specifically decreasing the exposure to any particular loan defaulting.