Partner Article

Why alternative finance is vital in today's volatile investment market

By Simon Lenney, North East-based independent chairman of Maven Bonds

In the wake of the worst global pandemic in living memory, North East business professionals are naturally concerned about their health and the welfare of their loved ones. Whilst this is top of the agenda, plenty of professionals will also be considering how to maintain the health of their investments.

In the current environment, the challenge for company CEOs, MDs and investors is to maximise the value of their spare cash. The COVID-19 outbreak has sent stock markets into a tailspin, decreasing the value of equity investments, and interest rate cuts have diminished potential returns on lower-risk investments. Falling asset prices have hit the pensions of millions of people and made it harder for firms to access finance. Surging bond yields have made it more expensive to fund spending plans and governments are reliant on central banks for the liquidity needed to pay out against their commitments – which include multi-billion-pound financial support packages to protect companies and jobs.

In this context, investors will be scratching their heads as they work out where to invest their cash in this new tax year. Their best strategy is to build a diverse investment portfolio, which allows them to spread risk over several investments. These could be traditional investments such as equities or alternative finance options that don’t fall into conventional asset classes such as stocks, bonds and cash.

Many investors choose ISAs as part of their portfolio. ISAs are attractive due to their tax efficiency and the fact that the new ISA allowance for 2020-21 has been reset at £20,000. But what types of ISA products are available?

Cash ISAs:

A cash ISA is a form of savings account that is offered by UK regulated banks and building societies. It’s a tax-free way of saving money, meaning that investors keep all of the interest that they earn, provided their deposits remain within the annual tax-free allowance (currently at £20,000 for the 2020/21 tax year). The original investment is protected and some providers offer a flexible facility that allows money to be withdrawn from the ISA, as long as this is done within the same tax year.

The big disadvantage of cash ISAs is the interest rates. In an ultra-low-interest economy – the Bank of England recently lowered the base rate to just 0.1% – no cash ISA offers a great return on investment, with highest returns of about 1.5% for a three-year fixed-term ISA and 1.25% for an easy-access ISA.

Despite these modest returns, this type of investment may be attractive to investors who want to shield cash reserves until stock markets become less volatile.

Stocks and shares ISAs:

One of the primary benefits of this type of investment is that the stock market tends to rise in value over time. This means that investors in it for the long haul are likely to generate reasonable returns, especially if they invest in defensive stocks such as pharma and food companies which generally produce returns for shareholders over time. Some stocks provide income in the form of a dividend, although this is less likely when the economy is struggling as it is now.

However, investors looking for a quick buck may find they lose as much as they had hoped to make. Sudden, unexpected events can cause dramatic fluctuations in stock prices, as seen in recent weeks as the COVID-19 crisis took hold. This has triggered a huge fall in markets around the world as factories and offices temporarily shut down, although on occasions there have been sudden upturns, possibly due to investors putting their money into stocks in the hope of buying low and cashing in on a subsequent upswing.

This volatility means that there is no guaranteed return on this type of investment, although potentially there is a lot of money to be made if the investment is well timed.

Innovative Finance ISA (IFISAs):

While cash ISAs and stocks and shares ISAs are generally viewed as traditional investments, Innovative Finance ISAs (IFISAs) fall into the “alternative” category.
In an ultra-low-interest economy, experienced high earners are now looking more closely at investments that have no direct correlation between the rise and fall of stock markets and towards asset classes, such as IFISAs, that offer the potential to generate more stable returns.

One of the reasons why IFISAs have proven to be so popular – and in fact, the reason why they were introduced initially – is that they allow investors to become involved in a growing alternative finance market, which was worth more than £6bn in the UK in 2017. Being able to invest under the ISA tax wrapper makes it even more of an attractive proposition; that’s currently £20,000 (as of 2020/21) that can be invested and any returns realised tax-free.

IFISAs allow investors to hold peer-to-peer (P2P) loans and debt-based securities under the generous ISA tax wrapper. A P2P loan is a loan made from an individual lender to consumers, and more recently, SMEs. P2P loans offer better rates for borrowers than are offered through traditional financing from banks, and better returns for lenders with target interest rates upwards of 6%. A debt-based security (or mini bond) is an asset-backed investment opportunity, taking in residential property developments and green energy projects and providing typical returns of 4-8%. Investors will usually be required to tie up their money in an IFISA for a fixed term, typically between two and four years. On some occasions these investments may even generate returns of more than 10%.

The downside of this is that higher rates generally equate to higher risk. The overall risk of IFISAs comes down to the underlying asset: business, consumer, property or green energy. Some investments will be secured against the asset – adding an additional peace of mind for the investor – but this doesn’t free the investment from risk entirely and in the event of an economic downturn, you may not get back the amount invested.

IFISAs are often seen as ethical investments which support an industry or cause – green energy or property, for example. It’s called ‘impact investing’, where the investment has the potential to deliver appropriate financial returns whilst creating a positive social, economic or environmental benefit. This is a powerful lure in an age where social conscience and responsibility are high on the agenda. Although economic activity has temporarily slowed due to the COVID-19 pandemic, clean energy projects will still be prioritised and affordable homes will still need to be built to address a chronic shortage.

So, what type of investment is best in an economic downturn?

There is no single investment that beats an economic downturn. The right investment for the investor will depend on his/her risk tolerance, savings war chest, financial goals and life circumstances.

From a wider perspective, the most important thing now is to try to recover from the impact of COVID-19. There needs to be a collective effort to help the economy bounce back – for example, by ensuring businesses have access to finance and house building schemes are fast-tracked from planning to development stage. This, in turn, will stimulate the investment market and give a much-needed confidence boost to investors who will be seeking to build balanced portfolios to spread risk across different asset classes.

ISAs are an increasingly important part of the portfolio mix. While cash ISAs offer a safe haven for cash in a volatile economic environment, stocks and shares ISAs remain a decent long-term option.

Meanwhile, IFISAs are an attractive alternative investment product that supports the growing alternative finance sector via P2P lending and asset-backed investments. This sector has grown into a mainstream market in the years since the financial crash of 2008, which made it more difficult for individuals and businesses to get affordable finance from mainstream banks and encouraged them to consider other forms of finance to fund projects that could reinvigorate the economy. Now, as the global economy tries to recover from the devastating impact of COVID-19, alternative finance will become even more important in the coming months, providing much-needed capital for businesses and projects that can drive economic growth.

The combination of tax-free returns and the opportunity to hold different types of ISAs means that investors will have plenty of options when considering how to weight their £20,000 ISA allowance in this new tax year. For many, ISAs will continue to be an important way to save and invest as they try to navigate their way through stormy economic seas.

This was posted in Bdaily's Members' News section by Growth Capital Ventures .