Popular P2P lenders like LendingClub do not make leverage immediately available to investors. In order to leverage a P2P portfolio, an investor would have to go elsewhere to borrow the capital necessary.
Some people use credit card balance transfers, home equity lines, or other consumer financing vehicles to add a bit of a kick to their P2P loan portfolios. That’s all fine and dandy, but I want to lower the cost of leverage, and increase its availability. Credit cards aren’t big enough, and home equity loans put your home on the line.
What about margin available from a brokerage account? 😉
We can synthesize leverage to boost returns.
For the purposes of this example we’ll assume that you’re well versed in investment principles. You’ve done your best to improve your portfolio ROI in the stock market, and you’ve nabbed a few exchange-traded funds for generating dividend income.
The SPDR S&P Dividend ETF (SDY) strikes your fancy because it contains the 50 highest yielding S&P500 components. As a fund, the current yield is just over 3.5% per year.
You’ve stashed away $100,000 in SDY, but now you want to explore the world of P2P lending. More importantly, you want to increase your total portfolio ROI. At 3.5% per year, the dividends aren’t just doing it any more. LendingClub’s yields, on the other hand, look better than ever.
Creating Leverage from Thin Air
TradeMONSTER offers awesome margin rates of 2.75% per year for investors with $50,000-$249,999 in their account. Investors can leverage up to 2:1 for only 2.75%, a small price to pay for short-term financing.
Seeing as you want to limit your risk of a margin call, you leverage your $100,000 SDY position by 1.66:1, essentially putting up $60,000 and borrowing the $40,000 remaining dollars from TradeMONSTER.
Now you’ve $40,000 in free capital to invest elsewhere. You could just hang out in the stock market, but 3.5% is nothing to write home about. On the other hand, LendingClub is throwing off net returns of >8% for investors, and the non-market correlation has you flat out stoked.
You can see where this is going. Like a champ, you throw that cash in your new P2P lending account.
Your SDY ETF generates $3,500 in annual cash flow
Your SDY margin costs 2.75%*$40,000, or $1100 per year
Total annual income: $2,400
Your $40,000 investment in 1600, $25 loans earns 7% per year.
Annual income: $2,800
By synthesizing margin from your brokerage account, you’ve created a net gain in annual returns equal to $5,200 less $3,500 in dividend income–$1,700. On your total investment less leverage, you’re looking at an annual cash return of 5.2% instead of 3.5%, a 50% improvement in returns!
So, what’s the risk?
Risks are small, to say the least. LendingClub boasts an impressive net return of 9% per year for all loans generated. I figured on the safe end at 7% per year. This also allows you to build in the cost of their account management feature, which comes at a cost of .8% per year.
The real risks are:
- Rising short-term rates – Your LendingClub loans will amortize over 3-5 years, but you’re borrowing in what is essentially the <3 month end of the curve. Technically it’s an overnight loan on the margin side, but that label doesn’t correspond well with the rate of interest paid.
- Stock market plunge – Assuming SDY is the only position you hold, a dip in the ETF by 40% would force a margin call, which would close you out at a $40,000 loss on the brokerage end. You’d still hold the $40,000 LendingClub portfolio, though.
- Margin call – If a massively huge never before seen financial crisis comes and the call money provider says “gimme my money back” you’re going to get closed out of the trade. (This is the kind of event only Dave Ramsey would lose sleep over.)
- Lending Club Underperforms – According to LendingClub, no investor with more than 800 loans lost money. The curve for returns appears to have a normal distribution, so there’s a very minimal chance of generating returns lower than the cost of TradeMONSTER margin cost.
And the benefits?
- Juiced returns – Even on the relatively safe end of the spectrum you could generate a move from 3.5% to 5.2%, which is awesome sauce.
- Unlimited upside – You have not reduced your total exposure to the SDY ETF. Your capital appreciation returns are the same regardless of leverage. If the SDY ETF rallies 20%, it’s all yours—all $20,000 of it.
- Non-market correlation – Whereas you could plow the margin back into the ETF, which is market correlated, the LendingClub account is non-market correlated. Non-market correlation means that your LC account isn’t going to go bust just because the S&P500 does.
All in all, I think it’s a pretty interesting way to amp returns. I’d consider it if my chosen equities weren’t on the small cap “FU for margin” list.