Twenty years of evidence: Is it time to reconsider microfinance?

Institutional investors are searching for sources of risk and return that diversify traditional portfolios. Yet assets with genuinely differentiated economic drivers have become increasingly difficult to identify. As correlations across many public and private market asset classes have risen during periods of market stress, diversification has often proved less robust than expected.

Against this backdrop, it is surprising that microfinance rarely features in strategic asset allocation discussions, at least in Switzerland. It has been part of selected institutional investment portfolios for more than two decades but is still often viewed primarily as an impact investment rather than as a source of portfolio diversification.

That perception increasingly appears outdated.

The explanation lies in the way microfinance generates returns and manages risk. Returns originate from diversified portfolios of relatively small loans to micro and small enterprises and households, where repayment capacity depends primarily on local economic activity and entrepreneurial cash flows. The associated credit risks are kept at bay through prudent lending practices such as dynamic incentives, close monitoring, restructuring and refinancing of delinquent loans.

Microfinance offers a source of diversification that differs structurally from traditional capital market exposures. While it is certainly not immune to macroeconomic developments, its underlying risk drivers differ from those of listed equities, fixed income, private equity and large parts of private credit. Much of this resilience traces back to the sector’s structural origins.

Microfinance institutions (MFIs) were historically built up with capital from development finance institutions (DFIs), whose mandate was never purely commercial but aimed at poverty alleviation and financial inclusion. Even as the sector commercialised and microfinance investment vehicles (MIVs) emerged as a distinct, return-oriented investor base, DFIs did not exit the market entirely – many MFIs continue to draw on both DFI and MIV funding side by side.

This coexistence matters: DFIs bring patient, long-term capital, high governance standards and established risk management practices, which in turn stabilise the MFIs they co-finance with commercial investors. Combined with rigorous credit risk management at both the MFI and MIV level – including provisioning for expected losses, restructuring distressed loans and broad diversification across borrowers, sectors and geographies – this layered structure allows shocks to be absorbed gradually rather than transmitted directly to investors.

“The value of microfinance lies in providing exposure to fundamentally different market structures that may enhance portfolio diversification”

The COVID-19 pandemic is a case in point. The sector was not spared: borrowers with very low incomes and little financial buffer were among the most exposed to the sudden income shocks of lockdowns, and loan disbursements by MFIs dropped by roughly 80% between February and April 2020, while repayments fell by around 50%. Yet the outcome was not a disorderly wave of defaults.

MFIs granted widespread payment deferrals and restructurings to borrowers, while MIVs, DFIs and banks extended and restructured their own claims on MFIs rather than calling them in individually. Several MIVs and DFIs signed coordination agreements and pledges committing to a joint approach to avoid uncoordinated bilateral actions that would undermine confidence and deepen the liquidity squeeze. Some MFIs still failed, particularly smaller ones unable to withstand the liquidity pressure.

The accumulated evidence suggests that microfinance has historically delivered moderate but stable risk-adjusted returns, broadly in line with comparable fixed income asset classes – in other words, a market-rate return rather than a concessionary one. For Swiss pension funds, this distinction matters because they are required to assess their investments against the criteria of return, security and liquidity, making the question of whether an asset class earns a market-rate return a regulatory necessity rather than a purely academic one. Rather than competing with traditional asset classes on return alone, the value of microfinance lies in providing exposure to fundamentally different market structures that may enhance portfolio diversification. As with any investment, historical performance offers no guarantee of future outcomes.

If the investment case has matured, why has institutional adoption remained relatively modest?

The answer appears to lie less in portfolio construction than in implementation. Microfinance remains a specialised market requiring dedicated manager selection, robust operational due diligence and a sound understanding of local lending ecosystems. For many pension funds, particularly smaller institutions with limited internal resources, allocating to such a strategy requires a meaningful governance budget. Unsurprisingly, familiar asset classes often receive priority.

“Compared with mainstream fixed income or private markets, institutional microfinance offers more limited investment capacity”

Market size also remains a practical consideration. Compared with mainstream fixed income or private markets, institutional microfinance offers more limited investment capacity. For larger pension funds, building meaningful allocations may therefore require greater planning and manager diversification.

Strong governance remains a prerequisite for every private market allocation. If an investment cannot be implemented transparently, monitored appropriately or adequately understood by the investment committee, restraint is entirely justified. This applies equally to infrastructure, private equity, private debt and microfinance. The objective should therefore not be to maximise diversification at any cost, but to ensure that every allocation fits the institution’s governance framework, implementation capabilities and long-term investment objectives.

Ultimately, asset allocation is not about identifying universally superior asset classes. It is about determining which investments best support a pension fund’s objectives within its specific governance framework, risk budget and implementation capabilities. The suitability of microfinance will therefore differ across institutions, as is true for every private market investment.

Microfinance will not be suitable for every institutional investor. However, after more than two decades of evidence, it arguably deserves to be evaluated alongside other private market investments – not primarily as an impact allocation, but in the context of an institution’s asset-liability management framework and governance capabilities.

Stefan Beiner is a partner at Swiss consultancy c-alm and former CIO of Publica, one of Switzerland’s largest pension funds