For income-oriented investors, current market conditions are posing a challenge.
Treasury bond yields are near historic lows, which makes it harder to generate income from what’s been a historically safer asset class. While equities offer potential for price appreciation and dividend payments, they’re also volatile and risky — perhaps too risky for someone seeking steady, reliable income from their portfolio. Whether you invest in a mutual fund, ETF or individual stocks and bonds, the predicament is similar.
Fortunately, the financial industry has a knack for meeting niche investor needs, and one such solution, launched at the turn of the century, is the so-called interval fund. In a nutshell, an interval fund’s unique characteristics (we’ll get to some of those) allow investors who can accept different types of risk to access a higher-yielding portfolio of assets that may not be available via a mutual fund or ETF. Given investors’ appetite for yield these days, it’s no surprise interval funds are gaining in popularity — 16 new funds were launched in 2018 alone, for example.
So, what is an interval fund, and what makes them unique?
IT’S ALL ABOUT LIQUIDITY
To understand what makes an interval fund unique, we need to briefly dig into the mechanics of markets.
Mutual funds and ETFs are open-end funds, and investors can buy and sell them any day the market is open. ETFs and mutual funds are highly liquid, meaning they can be bought and sold relatively easily.
When you purchase $100 of an ETF the fund manager purchases $100 worth of all the assets that make up that fund. When you sell $100, the fund manager sells $100 worth of its underlying assets (this is, of course, an oversimplification). This works well for an equity ETF, because all the stocks in that fund are easily bought and sold on major exchanges. However, these mechanics don’t work for assets that can’t be bought and sold very easily — they’re illiquid assets.
Basically, if you bought or sold $100 worth of a fund holding illiquid assets, fund managers would have a hard time buying or selling $100 of the fund’s underlying assets. Therefore, ETFs and mutual funds are prohibited from holding a high percentage of illiquid assets, such as certain high-yield bonds, bank loans, private debt, structured products and real estate.
But these types of assets have the potential to generate higher yields and long-term returns. So how can you invest in them? Enter, the interval fund.
THEY’RE NOT FOR TRADERS
Interval funds give investors access to those higher-yielding, alternative assets because the funds aren’t bought and sold like other funds. Each day, the funds are priced based on the net asset value (NAV) of all fund’s holdings (that’s the price you’ll pay per share). While you can buy most interval funds on any given day, you can’t sell them whenever you choose.
Instead, interval fund managers periodically buy back a predetermined percentage of the fund’s outstanding shares every 3, 6 or 12 months (most buy back on a quarterly basis). You must elect in advance to have your shares redeemed before the next buyback period. And if the redemption limit is reached, there’s no guarantee you’ll be able to sell all the shares you want to.
Essentially, you are giving up the ability to sell your shares easily in exchange for access to higher-yielding, alternative assets that were once only available to institutions and hedge funds. On the other side of the table, limiting redemptions allows fund managers to package these illiquid assets into funds.
INTERVAL FUND QUICK FACTS
Fees will be higher. In exchange for higher yields, investors also will typically pay higher fees. Interval funds require a hands-on approach from managers. They might be on the phones buying derivatives or private debt offerings or purchasing bonds that don’t trade on an exchange. Another reason those fees are higher is because funds rely on third-party providers to value the portfolio’s holdings. Since those are typically private securities, pricing takes a little more legwork and that leads to higher costs.
Minimum investments are higher. You may need to initially invest $25,000 or more to purchase shares of an interval fund. While this still pales in comparison to private equity, it may be a steep bar for some investors.
Day traders need not apply. Because these funds can’t be sold easily, interval funds are a better fit for investors who want to park capital for the long term. On the plus side, that discourages over-trading, which is often detrimental to long-term returns.
Manage volatility in a portfolio. These funds aren’t traded on exchanges, and the underlying assets have lower correlations to their publicly traded counterparts. That can help lower overall portfolio risk. However, there’s no evidence to suggest that interval funds, on their own, are any less volatile than corresponding mutual funds or ETFs. But, in a well-diversified portfolio, interval funds can help the right investors get access to assets with less correlation to assets traded on the broader market.
Wider opportunity set. Interval funds, on average, have potential to provide higher yields and returns than mutual funds or ETFs. That’s because they can invest in both public and private assets, giving them a wider universe of investment opportunities. Keep in mind, expanding opportunity in no way guarantees outperformance. Also, recall that fees are higher so the bar for net returns is a bit higher.
A FIT FOR YOU?
Since everyone’s financial picture is different, there’s no ideal investor for interval funds. Rather, if you’re interested in the unique characteristics of these funds, you may want to speak with your financial advisor. They can delve deeper into how these funds work, and whether they’d be a good fit for your broader financial plan.
No investment strategy can guarantee a profit or protect against loss. An investment in an interval fund is not suitable for all investors. Unlike an investment in a traditional listed closed-end fund, interval funds should be considered illiquid. Investors should consider their investment goals, time horizon and risk tolerance before investing.