Interval Funds; a Smarter Structure to Access Less Liquid Opportunities
Blair Reid, FIA
October 3, 2018“We live in the least liquid bond markets in history. That’s not a bad thing – it means an “illiquidity premium” is available to investors and interval funds, a ‘40 Act structure, offer an efficient way to access these opportunities.”
What is an Interval Fund?
An interval fund is a fund structure that is being rediscovered by both asset managers and investors. It is technically classified as a “closed-end” fund under the Investment Company Act of 1940 (“‘40 Act”) and while it may take in new investments daily, it only allows redemptions or buy backs at specified intervals, most commonly 5% each quarter. This key differentiator, specified liquidity intervals, allows asset managers to know the maximum amount that might potential be withdrawn at each interval and thus allows the managers to hold illiquid or less liquid assets without fear of excess short term redemptions.
The table below provides a brief comparison of various structures. Note that interval funds allow limited liquidity (5 – 25%) and the ability to invest in illiquid or less liquid investments, much like hedge funds, but with the structure and protections of the ‘40 Act. Exchange listed closed-end funds also provide for the use of illiquid investments, but investors’ purchase and sale is subject to market prices on the exchange which can be significantly different (premium or discount) to the fund’s NAV. Open-end and exchange-traded funds are limited to 15% in illiquid investments. Interval funds occupy an attractive middle ground between daily vehicles, which have tight restrictions on less liquid assets, and hedge funds, which have less uniform or regulated formats.
A fund manager’s perspective on interval funds. . .
From a fund manager’s viewpoint, interval funds possess a number of desirable characteristics:
- Interval funds enhance the ability for investors to earn an “illiquidity premium”
One key advantage of the structure is the ability for an asset manager to expose investors to less liquid opportunities which may offer higher long-term returns. As the structure gives the manager visibility on the maximum potential outflow, less liquid opportunities can be held without fear of having to sell unexpectedly at unattractive prices.
- Advantageous for liquid opportunities with longer time horizons
Fund managers often have ideas which take months, or longer, to play out. These opportunities can be in liquid securities, though time horizon is required to maximise the gain. The interval fund structure facilitates managers incorporating these opportunities in the knowledge they are unlikely to have to be sold prematurely.
- Longer-term investment*
vehicles, like mutual funds and exchange-traded funds, offer daily or even intra-day liquidity. Looking out over 20+ years for example, a daily liquid vehicle would give an investor 5000+ liquidity points over the life of the investment (approximately 250 trading days per year x 20 + years); an interval fund might offer only 80 or so liquidity points in the same example (quarterly liquidity 4 x year x 20+ years). Many investors have a tendency to sell when prices decline, crystalizing losses and increasing transaction costs. Interval Funds, with their periodic redemptions windows, encourage investors to take a longer term perspective, which is usually more consistent with their investment horizon.
*An interval fund is not suitable for investors who may need the money they invest within a specified timeframe. Interval funds are suitable only for investors who can bear the risks associated with the fund’s limited liquidity and should be viewed as a long-term investment.
Where to from here?
At present there are some 50 or so interval funds with nearly as many now in registration in the U.S.; many of them for bond-based strategies. In our view, the interval fund structure's time has come, with a unique combination of less liquid markets, investors seeking diversified sources of value add and regulatory preference for vehicles that better align market and vehicle liquidity.
Important Risk Disclosure
Because of the risks associated with investing in high-yield securities, an investment in the Fund should be considered speculative.
An investment in interval funds involves a high degree of risk. In particular: The fund’s shares will not be listed on an exchange in the foreseeable future, if at all. It is not anticipated that a secondary market for shares will develop and an investment in an interval fund is not suitable for investors who may need the money they invest within a specified timeframe. Interval funds are suitable only for investors who can bear the risks associated with the fund’s limited liquidity and should be viewed as a long-term investment. The amount of distributions that the fund may pay, if any, is uncertain. The fund may pay distributions in significant part from sources that may not be available in the future and that are unrelated to the fund’s performance, such as a return of capital, borrowings or expense reimbursements and waivers. Interval funds may use leverage which may cause a portfolio to liquidate positions when it may not be advantageous to do so to satisfy its obligations or to meet segregation requirements. Leverage, including borrowing, may cause a portfolio to be more volatile than if the portfolio had not been leveraged.