Publications

- July 1, 2017: Vol. 4, Number 7

The Rise of Interval Funds: Institutional-style alternative investments for the retail client

by Dana Woodbury

For astute investors seeking higher yielding assets, their greatest challenge may be finding ways to buy and sell them. Then came a structure called the “interval fund.” Typically available only to institutional investors — who get paid a premium for holding illiquid assets such as private loans, structured credit or commercial real estate debt — regulations from the Securities and Exchange Commission make significant allocations to such asset classes impossible in ordinary mutual funds.

Individual investors may have found a solution with interval funds. Though not a mutual fund, interval funds are available to individuals without requiring high minimum investments, and they offer investors the flexibility to participate in the kinds of high-yielding, low-liquidity investments in which private equity and hedge funds invest. Like mutual funds, interval funds are priced daily, with the ability to continually offer their shares to the public. Unlike mutual funds, there is no restriction on their access to private (illiquid) investments, providing opportunities for higher yields.

Interval funds are considered closed-end funds that offer daily purchase for investment, but liquidity for limited redemptions at specific intervals (usually quarterly). Legally, interval funds are classified as closed-end funds, but they are very different from traditional closed-end funds in that:

  • Their shares typically do not trade on the secondary market. Instead, their shares are subject to periodic repurchase offers by the fund at a price based on net asset value (NAV).
  • They are permitted to continuously offer their shares at a price based on the fund’s NAV but are not listed on an exchange, so they don’t trade above or below NAV the way regular closed-end funds do.

According to Morningstar, there are more than 20 interval funds in registration, which is equal to two-thirds of their current universe. Many funds offer minimum investments as low as $2,500, with the caveat that they should only be offered to investors who can bear the risks associated with limited liquidity, and should be viewed as a long-term investment. That said, these restrictions help fund managers take a longer term approach and avoid fire sales of assets at cheap prices. During times of sudden, massive redemptions, these restrictions may help boost returns. In addition, thanks to their largely illiquid structure, which allows fund managers to invest without the pressure of ongoing redemptions, interval funds tend to provide higher returns than open-end mutual funds.

The primary reason to own interval funds, according to Morningstar analysts Cara Esser and Brian Moriarty, is “to gain access to these illiquid markets and earn a high payout.” Those markets include catastrophe bonds, hedge funds, real estate securities and small-business loans.

Interval funds provide retail investors with access to institutional-grade alternative investments with relatively low minimums. However, there are several drawbacks including higher fees and restrictions on withdrawals. Some funds allow only 5 percent of assets to be redeemed each quarter. If too many investors tender shares, each order is prorated. When the fund makes a repurchase offer to its shareholders, it will specify a date by which shareholders must accept the repurchase offer and the actual repurchase will occur at a later, specified date. The repurchase pricing date typically occurs after shareholders submit their repurchase requests. Depending on the volatility of the underlying investments, the fund’s NAV could fluctuate significantly prior to the repurchase pricing date.

CHANGES IN THE INDUSTRY

Financial advisers considering interval funds should take into account what portion of their clients’ portfolios could tolerate the long-term commitment required for this type of vehicle. Although some funds may offer 5 percent to 25 percent liquidity per interval (typically quarterly, but may be semi-annually or annually), a maximum drawdown could have a significant impact on the NAV. When considering an interval fund, financial advisers should examine:

Level of liquidity and transparency: The liquidity feature of the interval fund structure is an important characteristic. Therefore, a significant level of liquid assets held in the fund will ensure the ability to meet redemptions. Further, the significant weight to liquid assets improves pricing transparency for investors.

Internal investment management versus fund-of-funds approach: This relates to whether the fund outsources investment management or keeps this function in house. This internal investment management is often performed by the fund’s sponsor, allowing better risk control and more accountability, in addition to potentially lower costs. Interval funds that use an outside manager may charge higher fees, suggesting a thorough understanding of the outside manager’s added value is critical.

Fee structure: Interval funds are known for having higher fees than their mutual fund counter parts, but fee structures vary across the board. Interval funds are permitted to charge a redemption fee not to exceed 2 percent of the repurchase proceeds. Other fees may include upfront sales charges ranging from 0 percent to 6 percent, ongoing management fees of 1 percent to 1.5 percent, shareholder servicing fees of 0 percent to 0.25 percent, and fees associated with the underlying portfolio, which may or may not be disclosed, but are factored in to the NAV.

Conflicts of interest: Conflicts can arise if the portfolio manager is allowed to invest in other funds of the sponsor. Further, the fund may be permitted to loan its portfolio securities to other entities. The most transparent outcome (to ensure no conflicts) is to preclude the fund from investing in other funds of the sponsor.

Source of distributions: Be leery of distributions that represent a return of capital. Some interval funds will artificially inflate their distribution to attract new investors. In such instances, tracking the source of distributions is imperative to determine the impact it might have on the return of your original investment, in addition to determining if the source of distributions over time is increasingly from net operating income.

IN SUMMARY

Interval funds — regulated primarily under the Investment Company Act of 1940 and also subject to the Securities Act of 1933 and the Securities Exchange Act of 1934 — represent an opportunity for investors seeking higher yields to gain access to private investments previously available exclusively to institutional investors. Interval funds can provide a degree of liquidity that may assist financial advisers in diversifying their clients’ portfolios, without overly constraining their need for liquidity. The field of interval funds is growing, yet there are already choices ranging from real estate equity to debt, and private equity to structured credit. Investors have many choices when determining the best allocation for their specific risk tolerance.

Dana Woodbury (dwoodbury@buttonwoodllc.net) is founder and chairman of Buttonwood Investment Services, a third-party provider of due diligence.

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