How to build a portfolio of P2P lenders – and earn a tasty income

You can get better returns if you go alternative.

Over the last year, the alternative finance (altfi) sector has grown at a staggering pace. The lending side, once dominated by Zopa, RateSetter and Funding Circle, has seen a flood of new competitors.

Rates on offer have widened too you can get anything from 2.9% a year (for RateSetter's one-month product) to well above 10% for younger platforms lending to small businesses. This makes P2P lending (also known as 'marketplace lending') a viable asset class in its own right for income investors.

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But how do the returns on offer compare to traditional income sources, and what yield should an investor be aiming for in putting together their altfi portfolio? The table below looks at some more "traditional" sources of investment income government bonds, corporate bonds and UK savings accounts (the last is based on data from Moneyfacts).

I reckon that by taking the current yield from three different sources you can get a sensible idea of the sort of yield you can hope for from this route. There's an iShares exchange-traded fund (ETF) tracking the gilts market that offers an average running yield of 2.13%.

Another iShares ETF, tracking sterling corporate bonds, yields 2.62%. Finally, there's the Investec High Five deposit account (now closed to new clients), which pays out the average of the top five gross interest rates from bigger banks and building societies (as per the best-buy tables on the Moneyfacts website). This is currently paying 1.28%.

The alternative lenders

Firstly, the underlying borrower who you are lending your money to varies from consumers (largely) at RateSetter and Zopa, to businesses at Funding Circle (and its much smaller rival FundingKnight), through to buy-to-let landlords targeted by the likes of Landbay.

Secondly, some platforms are more established than others some have seen hundreds of millions of transactions, others just tens of millions.

Thirdly, a few platforms offer loans with some asset backing behind them (property-backed products spring to mind). An even smaller number offer some form of protection fund, though these may or may not insure you against future losses.

Fourthly, remember that the returns quoted are largely estimates from an industry that is growing very rapidly, so the headline rates are likely to be based largely on past trends, not future flows ofmoney (and bear in mind that we've yet to see a classic sell off following a big spike in loan losses, so whether these headline yields look the same in one or two years' time is anyone's guess).

Finally, the length of loans varies hugely put simply, the longer the loan period, the higher the probable income yield.

If you can't be bothered poring over the chart, the key number to focus on is the one in red the "AltFi Data LARI index". This crunches data on masses of loans outstanding for Zopa, RateSetter and Funding Circle. It currently shows a blended, all-in return (in yield) of 5.15% across these three platforms.

Diversification is key

You could do this by investing your money in a closed-end fund, such as the P2P Global Investments fund (LSE: P2PGI) or the Victory Park fund VPC Lending (LSE: VSL), and letting a fund manager do the diversification work for you.

But if you'd rather build a simple portfolio yourself, what sort of yield should you aim for? The LARI index suggests that a 5.15% return has been possible by using the three biggest platforms. But I reckon a more adventurous investor could push this a bit higher using what I call the alternative 60/40 strategy.

In conventional investment, the 60/40 strategy is elegantly simple it suggests that on average 60% of your capital should go into the most risky assets such as equities, while 40% should be placed in less risky bonds.

It's a rough and ready rule, but over time it seems useful in producing solid risk-adjusted returns over a ten-to-20-year timeframe the less risky bonds help to smooth out the more volatile returns from equities, giving you a less stressful ride without compromising your returns badly.

My alternative 60/40 strategy involves putting 60% of your cash in the platforms tracked by the LARI index (Funding Circle, RateSetter and Zopa) and 40% in smaller, less prominent platforms and their products. In my ideal world I'd probably put half of that latter 40% in platforms orientated towards property lending, and the other half into more specialist business lenders.

So, for example, 20% would go into property-based platforms, such as LendInvest, Wellesley & Co and Landbay, and the other 20% would go into the likes of Assetz, ThinCats, and Funding Knight.

At a rough and ready estimate, I think an investor might be able to run a portfolio of just seven platforms (the three big ones in the LARI and two each for property and specialist small-to-medium enterprise lending) with an overall yield of just a tad under 6% a year. In future articles, I'll put this to the test by building a portfolio of P2P loans and then tracking performance in real time watch this space.

Read more about alternative finance at David's website, altfi.com.