Focus: Microfinance is a Handy Tool in a Diversified Portfolio

Feb 2009
London, United Kingdom, February, 23 2009 - In spite of scepticism about it being an 'unknown' asset class, microfinance is establishing itself as a useful way to expand diversified portfolios.

A new asset class that delivers decent returns, low volatility, low correlation with all equity markets, particularly developed - and even fits what Richard Branson describes as "capitalism with a conscience" - still struggles to convince advisers.

The asset class, or subset of emerging market fixed income, is microfinance. Microfinance institutions (MFIs) make small loans to the working poor, mostly in developing countries, over short periods. A microfinance fund lends money to the MFIs at an interest rate that is typically 10 per cent.

On paper it is perfectly shaped to establish itself as part of an asset-class tool box used to construct diversified portfolios. The challenge for advisers is always whether to embrace new investment options in the quest for better portfolio performance and reduced volatility, or to hang back for fear of their clients getting 'burned'. Many advisers have seen investment classes such as zeros, hedge funds and Reits gain traction in the past 10 years, but just as they have bravely dived in, performance has dived too.

Microfinance would seem to have its work cut out. Not only is it an 'unknown' asset class with sticky liquidity, but AMCs are also high due to the hands-on management required. Its exposure to frontier and emerging markets also encourages advisers to perceive it as risky.

It is crucial that advisers take the time to understand risk and how genuine diversification can mitigate it. Microfinance is simply part of a broad asset mix that brings genuine diversification and includes equities and debt across the UK, US, Asia and emerging markets as well as timber, multi-strategy absolute return funds, private equity, commodities funds and structured products.

Sure, many advisers have had their fingers burned with zeros, hedge funds, Reits and so on, but this may have more to do with undertaking the right level of due diligence and understanding the asset being purchased. Most advisers have stuck to funds of hedge funds, and last year the well-managed among these were down less than most corporate bond indices, let alone equity indices. The issue with Reit funds was about investing at the top of the market.

Microfinance is relatively new and the demand for it is huge. It has the look of a sector establishing itself - rather that a market that is saturated - and is already well on the way to achieving this in the Netherlands.

For some clients, investing is about more than risk and return - it is also about the social and environmental effect of their investments. These investors are often described as 'ethical' but we need to revisit this somehow. Perhaps some new terms are needed to do justice to the variety of objectives emphasised by these investors and the investment options that seek to match them.

Ethical funds are generally characterised by a negative screen that excludes companies that directly engage in cigarettes, pornography, the arms trade and other such 'sin stocks'. These screens often exclude involvement in industries with which many ethical investors have no issue - or even wish to encourage - such as nuclear power or GM foods. At the same time, many ethical investors think negative screening can be petty or needless. One ethical fund refused to buy shares in WHSmith because it had a few soft ‘exotic’ magazines on its shelves.

Ethical funds can also have a bias towards UK smaller companies, so allocating more than 10 per cent to them can unbalance a portfolio. How do you asset allocate effectively without the risk of compromising your beliefs? Do you buy an overseas equity fund, for example, filtering only from a very limited range of ethical funds, or go mainstream and risk including the very industry you wish to avoid? The ability to pursue both your fund selection objectives and ethical ideals is challenging.

The term socially responsible investment (SRI) is increasingly popular in the institutional space, but for private clients perhaps socially motivated investment (SMI) fits best. After all, it is a question of judgement whether WHSmith or British Energy is ethical or not. The key question is: does investing in one company over another, based on what they sell or do, really satisfy a socially motivated investor?

Someone who needs a diversified portfolio that is going to give a good return and include elements offering a positive social effect is going to want more. Such clients find microfinance genuinely engaging. It affects millions of lives in developing countries, empowers people and stimulates local economies.

Turning back to the issue of what constitutes 'ethical', we have to ask whether any of the budding entrepreneurs who get a hand up through microfinance go on to engage in enterprises that are less edifying than the initial fishing, basket weaving or sewing. Probably. Taking an SMI approach does not avoid the reality that no investor, ethical or otherwise, can know the myriad consequences of an investment, but the benefits can significantly outweigh these potential consequences.

The social impact microfinance has had since its emergence is impossible to measure, but a recent study estimated that more than 80 per cent of poor families in Bangladesh have been positively affected as a result of microfinance. Dr Muhammad Yunnus, who pioneered microfinance in Bangladesh, won the Nobel Peace Prize in 2006 for his work.

The combination of this social impact and the potential for returns of roughly 7-10 per cent before charges has been described as a double bottom line. With global demand for these small loans estimated at $280bn (£197bn) and supply at $25bn, microfinance’s double bottom line looks like a story that is only just beginning.

Of course, as with any investment there are risks. Although the funds lent by MFIs tend to cover a number of countries, mitigating local currency risk, this does not eradicate the risk altogether. Credit risk at MFI level is also an issue. Default rates of 2-4 per cent are encouraging but clearly demonstrate how critical the fund manager’s due diligence on each MFI is.

The microfinance sector grew by 17 per cent last year, according to figures from Mix Market, a microfinance information platform. A report by Deutsche Bank, An Emerging Investment Opportunity, stated public and private investments in microfinance doubled between 2004 and 2007, suggesting last year’s growth was part of an ongoing trend.

In conclusion, like many asset classes that began as niche opportunities - such as student property funds or commodities funds - private clients and their advisers will increasingly view microfinance as a viable part of mainstream portfolios. Indeed, one reason for the emerging demand for microfinance funds is that they work very well in portfolios during times of market uncertainty.

Source : FT Advisers

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