Microfinance: an opportunity to invest for impact and financial returns

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What is microfinance?

Microfinance provides financial services, like loans, savings and insurance to those excluded from the “normal” financial system. This could be because the transaction sizes are too small or the customers are too remote for traditional banks to serve.

Perhaps think of a very small loan, maybe $50, to buy stock for a market stall or to buy seeds to grow produce. Or insurance to cover that stock or business. Or a simple savings product providing a safe place to save. Loans are the segment of microfinance focussed on in this article, specifically, lending to microfinance institutions, who then make a large number of small loans to individuals. Other parts of the microfinance ecosystem are also investable.

Microfinance as an asset class remains largely overlooked by institutional investors. In this article, I set out the compelling case for investing in microfinance, and aim to bust some common myths that might have previously prevented investments.

As well as the investment case, there is the positive social impact of the asset class – to foster economic independence, reduce poverty, and promote financial inclusion for those without access to financial services, particularly in developing countries. This is achieved by bringing more people and businesses into the formal financial system.

So what's the investment opportunity?

There are two main complementary reasons to consider an investment in microfinance:

Attractive risk/return profile, when compared to other similar asset classes (and particularly from a fixed income perspective, at a time when spreads are very low in corporate bonds and ABS).
The positive social impact.

In this article I focus on “microcredit”, ie liquid (monthly redemptions after a notice period), open-ended debt strategies, as they invest predominately in established microfinance institutions. Few investors are aware how strong and stable returns have been in this space.

The chart shows the highly stable cumulative performance, after fees, of two of the main funds we track in this space aggregated through a 50/50 split (purple line). We’ve compared this against global bonds and cash indices. The target returns for the two underlying microfinance funds range from cash +2 to +4% pa (net). The stability of returns for each individual microfinance fund is virtually the same as for the aggregated line in the chart, with each fund achieving its target since inception (going back more than 17 and 28 years).

The comparison above isn’t perfect as microfinance exposures/characteristics are very different to those of other asset classes, even emerging market debt. Although microfinance mainly consists of short-term loans, it is not liquid in the way the other asset classes on the chart are, and there is no secondary market for the underlying loans. However, the charts do show that microfinance has a proven track record of extraordinarily stable returns through a range of market crises and conditions where other asset classes struggle. The low volatility is a structural feature of the asset class based on the short duration of loans, a predictable loss profile, a smooth adjustment to interest rate changes and a low correlation to other global capital markets; indeed, the end borrowers principally have a local focus with limited reliance on international capital markets, while the microfinance institutions are supported by adequate capital buffers and local regulatory oversight.

Microfinance aims to bring in parts of society who do not currently have access to the financial system. They are excluded from the mainstream financial system primarily due to the low value of their wealth and transaction sizes, as well as their rural locations. However, they make up a huge population. Institutional investors can capitalise on this while at the same time helping the ‘unbanked’ (there are over 1.3 billion worldwide). The flow chart below shows how this works in practice (and, for comparison, the stages of an investment-grade Asset Backed Securities investment is shown alongside).

Look familiar? For those already invested in Asset Backed Securities (“ABS”), a popular and well-established asset class for institutional investors, the mechanism is somewhat different, but the end result is similar. Both asset classes ultimately provide exposure to a large number of loans to individuals/businesses. The key differences? Microfinance lends largely to those in developing countries, whilst ABS typically covers developed markets and has look-through to the underlying loans. Microfinance makes loans predominantly to help start and support small businesses, whilst ABS takes exposure to credit cards, car loans, mortgages and similar, freeing up the balance sheets of lenders and financing more loans. Often the loans received by the end recipients of microfinance are smaller than the underlying ABS exposures. As an investor, the net returns you experience investing in microfinance have proven to be less volatile than investment-grade ABS over time, although some of this is a result of differences in the way these two assets are priced.

Another important social good to recognise is that the funds we track will make sure that interest rates for end users are not excessive and they can help end-users with financial literacy. Without well-governed financial institutions that follow established guidelines or are regulated by home supervisory authorities, money lending in these markets can become dominated by unregulated loan sharks, charging extortionate rates. Well governed institutions should also ensure fair treatment of any customers in difficulty, as well as having established work-out arrangements for poor performing loans. This is particularly important given that the underlying loan rates appear high relative to those in developed markets – it should be noted, though, that loan rates in developing nations reflect local rates and relative risk. An investment in microfinance can support the establishment and existence of well-regulated financial institutions in less developed markets, benefitting individuals and economies.

The two examples below detail how long-term support from microfinance institutions can contribute to the success of small businesses, to the benefit of the wider community. Both examples are loans made by microfinance institutions and the beneficiaries continue to make use of microfinance to this day.

In the small Southeast Asian country of Timor-Leste, a financial institution was established in 2001 and has played a key role in the country’s post-conflict reconstruction.

Teresinha reopened her rice kiosk following conflict following a $500 loan
The loan was used to restock and reopen the kiosk
There were few other financial institutions offering credit to small businesses at the time
She has subsequently expanded and diversified her operations through reinvesting profits
Today she is on her fifth loan cycle, having accessed $50,000 offered by the financial institution
Her business now includes transport, hospitality, and rental property
Her repayment record is flawless
Her business success has allowed her to educate her five children, one of whom is now studying at a university abroad

In 1991 Banpro was founded to catalyse economic development in Nicaragua by supporting a range of industries through the provision of working capital loans and revolving credit lines alongside running dedicated financial education programmes.

Lucia initially started her restaurant “Santa Lucia” from her family home in Managua as an informal business over 20 years ago
After formalising the business, it earned a reputation for high-quality food and service and expanded rapidly
In 2011, Lucia took a $69,000 loan from Banpro to finance the renovation and expansion of the main restaurant
By 2024, Banpro’s credit line had increased to $360,000, financing new ovens, cold storage, and solar panel installation
Banpro also continued to provide regular advisory support
At the time, Lucia employed over 50 people across four women-managed locations, prioritising staff development and enjoying low turnover
The restaurant supported local microentrepreneurs, by sourcing ingredients from five women-led suppliers
Lucia received the “Businesswoman of the Year” award in 2024 from the Nicaraguan Chamber of commerce of Services and Tourism

Busting myths and addressing concerns

Some of the key aspects that potential investors focus on before investing include:

developing market exposure
volatility of associated currencies
liquidity
reputational risks if end-users are taken advantage of
rise of fintech, ie financial technology, often through mobile phones, as a potential threat to traditional microfinance institutions

How to deal with concerns

In this section I expand on each of these issues and exemplify how good microfinance fund managers deal with them.

: A recent analysis stated the obvious, that when sovereign nations default, their economy does not stop completely. Further, it stated that enterprises in developing countries often have strategies that allow them to continue regardless of the economic state of the sovereign and that their default risks are different. The microfinance strategies we follow are well diversified across different countries and regions. They are also diversified across multiple borrowers.

: The microfinance strategies we track are well diversified by geography and offer loans to higher-tier microfinance institutions in hard currencies such as USD. Those microfinance institutions that operate in a single location typically then make loans in the local currency. The USD to local currency mismatch is a risk that the microfinance institutions face and is assessed and mitigated by good microfinance fund managers (e.g. through loan covenants).

: Open-ended microfinance funds are typically priced monthly with corresponding redemption periods (with notice required). Valuations are event‑driven, policy‑based, and anchored in credit fundamentals, not in continuous trading activity. And with around one third to a half of a portfolio maturing each year, there is sufficient liquidity to accommodate redemption requests.

: It is important that microfinance fund managers have a local presence across the different continents they invest in and that they put in the work to reduce the risk of investing in an institution that charges extortionate rates to end users of the finance. There is a lot of work to do, and the fees charged by fund managers for these strategies reflect that, with total expense ratios often around 1.4% pa.

: Fintech can be seen as both a threat and an enabler of microfinance. It can be seen as a disruptor, allowing the unbanked to bypass microfinance institutions to access financial services directly via their phones. But it also has great benefits in its speed and cost reduction potential. Microfinance institutions can use it to cut costs, to reach remote areas via mobile technology, speed up transactions and for analysis to better understand risks. Since the opportunity set of unbanked people in the world is vast, and the fund managers we rate have embraced fintech to further the reach of micro financial services and to develop new products, I would suggest that fintech could be seen as more complementary to microfinance than something that undermines the asset class.

Conclusion

Microfinance has an enviable long term track record of strong risk-adjusted returns, which have been tested and have proven resilient through various cycles, crises and market crashes; far more so than assets with equivalent credit ratings. In an environment where corporate bond and ABS spreads are very low, now is the time to consider other forms of credit to generate returns. Microfinance has been yielding around 8% pa recently and has been widely overlooked, but can provide attractive risk-adjusted returns after fees, diversifying exposure to different economies and end-borrowers, as well as producing positive social impact.

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Your questions answered

: Microfinance investing provides capital to financial institutions that offer loans and other financial services to individuals and small businesses that are underserved by traditional banks. It aims to generate financial returns while supporting financial inclusion and economic development.

: Microfinance can offer attractive risk-adjusted returns, portfolio diversification and positive social impact. By increasing access to financial services, it helps support entrepreneurship, reduce poverty and promote economic resilience in developing markets.

: While microfinance involves exposure to developing markets, investments are typically diversified across countries, regions and borrowers. Experienced fund managers also use robust risk management processes to help mitigate credit, currency and operational risks.

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