Diversification effects of microfinance investments

Diversification effects of microfinance investments

•           The study by Invest in Visions proves it: Microfinance is resilient to various economic cycles and market disruptions
•           Increased diversification potential and improved risk-return ratio with microfinance

Until now, it was generally assumed that microfinance funds are suitable for diversifying a portfolio because they perform uncorrelated to traditional asset classes and thus reduce the overall risk. In collaboration with the Technical University of Cologne (Technische Hochschule Köln), Invest in Visions has scientifically analysed the diversification effects of the microfinance asset class for the first time over a long period of 18 years.

The result: microfinance has the potential to improve the risk-return ratio of a classic mixed portfolio, but new trends are emerging with regard to the direction and strength of the correlation and investors need to differentiate the proportion of microfinance in the portfolio more strongly, especially in times of (financial) crisis.

An asset class in turbulent times

As a classic impact investing product, microfinance claims to achieve a social impact in addition to financial performance. In the white paper, the authors first analyse the scientific debate on the poverty-reducing effect of microloans and then go into the historical diversification effects. The majority of macroeconomic studies published in the past have already shown a clear link between the spread of microfinance and a reduction in poverty and income inequality.

The results of the analyses on diversification effects and portfolio optimisation are now far more exciting: for the first time, the correlation analyses of all indices were examined over the course of a year and over three 6-year periods. Older studies were regularly limited in their informative value due to short time periods or a small number of microfinance funds analysed.

The results of the analyses reveal some surprising findings: it turns out that negative correlations became weaker and positive correlations stronger with each period. The Symbiotics Microfinance Index (SMX) as a benchmark for the asset class was compared with indices of the bond, equity, money and crypto markets. In addition, a distinction was made between traditional and sustainability-oriented indices (naturally, the observation period for the crypto index and the sustainability-oriented investments was shorter than 18 years).

It is noticeable that there is a positive correlation in the traditional bond sector, while the traditional equity markets show no statistically significant correlation. It is worth noting that the correlation between microfinance and bond markets becomes increasingly stronger over time. Equally striking is the development of the correlation coefficient. For example, the coefficient of the MSCI Emerging Market Index was -.345 in the first six-year period, -.189 in the second period and then a remarkable +.127 in the third six-year period. This shows by way of example that the diversification potential of microfinance can also fluctuate considerably.

Edda Schröder, Founder and Managing Director of Invest in Visions, explains: „The microfinance asset class can generally be suitable for portfolio diversification, as this asset class tends to be resilient to various economic cycles and market disruptions. However, you should also diversify and invest globally.“

The analysis therefore also examined correlation behaviour in times of crisis, when diversification potential is generally most important. To this end, behaviour was analysed during the financial crisis, during coronavirus, at the start of the Russia-Ukraine conflict and in the crisis year 2015. Even during the peak phases of the respective crises, microfinance yields did not rise above the +/- 1% mark. This illustrates how low the volatility of the microfinance sector is, particularly in volatile capital markets. However, the number of significantly strongly positively correlated indices doubled during the coronavirus crisis year 2020 compared to the same period in the previous year. According to the study, if such shifts towards positive correlation were to occur, particularly during crises, this would significantly reduce the risk reduction effect. After all, the relatively constant returns of microfinance would then no longer serve as a counterbalance to the falling prices of the other markets to the same extent. Risk hedging would be reduced.

Microfinance in the portfolio reduces the overall risk

Finally, in order to assess the diversification potential, portfolios with different target values were constructed and compared for traditional, sustainability-orientated microfinance investments. The empirical analyses show that in an equally weighted portfolio of different asset classes, the standard deviation of returns decreases as the microfinance share increases. This is due to the low correlation of the SMX with the other indices, which fluctuates significantly less around its mean value than the benchmark indices over the entire observation period (shortened period for sustainable and crypto indices). Microfinance can therefore reduce the overall risk regardless of the weighting. At the same time, greater diversification benefits can be achieved than with comparable equity and bond indices from the sustainability sector.

The study has made it clear that microfinance still has the potential to diversify a portfolio of traditional asset classes and significantly reduce risk. At the same time, however, sustainability-oriented investors must also expect a drop in returns if they integrate microfinance into their portfolio. „For risk-averse investors in particular, microfinance is therefore an attractive investment that

The full study can be downloaded here:
https://www.investinvisions.com/en/blog/press-releases/diversification-effects-of-microfinance-investments/

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