New Investment Vehicle: Interval Funds

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Everyone has heard of stocks, bonds, mutual funds, and probably even ETFs. But have you heard of "interval" funds? No? You might want to remedy that! Their popularity is zooming. So, what is an interval fund and, more importantly, is it a good option for you?

What Exactly Is An Interval Fund?

Think of an interval fund as a mutual fund with a short window for buying or selling shares. With a typical mutual fund, prices are published daily and you can buy or sell your shares anytime with few restrictions. This makes mutual funds very liquid, i.e. you can easily and immediately cash-in your shares.

An interval fund operates similarly to a mutual fund in that prices change daily. However, you can only buy or sell shares during an "open window" period. That may happen every three, six, or twelve months, depending on the fund’s strategy.

Despite the restrictions, the popularity of interval funds continues to rise. According to investment banking firm, Robert A. Stanger & Co, 27 interval funds were in operation with another 20 in the pipeline (Barron’s, September 2016). PIMCO, one of the bigger names in the mutual fund world, registered its first interval fund earlier this year.

The "Interval Fund" Strategy

Some investments aren't well-suited for mutual funds that offer daily liquidity. Take real estate, for example. If a mutual fund held a parking garage, strip mall or an apartment complex, any of those properties could take months to sell. If significant investors decided to exercise their right to sell, the mutual fund manager may be forced to liquidate the properties quickly. That often means the selling price is way below the true value. This action hurts both the remaining fund owners as well as the investors who are selling their shares.

An interval fund's objective is to reduce the risk of forced sales of illiquid assets by limiting the sale of its shares. The restrictions help to protect both existing and exiting shareholders. While this may not appeal to everyone, it is a good fit for those investors who have a longer time horizon and desire a position in what are generally considered illiquid investments for a portion of their portfolio.

The Upside

An interval fund can give investors access to opportunities that generally require a longer holding period to achieve a positive return. Investments in timber, loan/debts, agriculture, real estate, and reinsurance are examples. The interval fund format provides investors the opportunity to achieve the diversification of a mutual fund, while having the protections in place to avoid untimely exits and costly loss of asset value.

The Downside

Interval funds do have pitfalls and concerns. Therefore, like any investment, it is important to understand how an interval fund works and how it differs from other investment vehicles.

Restrictions on Selling. The interval fund will only allow a shareholder to sell their shares during a specific "open window" time period. In addition, the fund's management also has the option to limit the amount of an investor's holdings that can be sold at one time. For example, an investor may be able to sell every three months, but be limited to selling no more than 5 percent of his/her total position in the fund. This protects the fund by limiting the potential cash needed during a selling period, but could potentially require significant time for an investor to fully liquidate their position.

Less Transparency. Illiquid products can be less transparent because of the difficulty to price the underlying assets on a regular basis. For this reason, it is important to know how the interval fund values its investments. Utilizing a third party to price the assets is more desirable and can provide more transparency than the fund management performing its own valuation process.

Fees. Generally, fees are expected to be higher (2 percent and above) on an illiquid investment strategy since it’s more costly for the investment firm to research, do its due diligence, and to buy and sell the assets. Be sure to understand the relationship between "all-in" fees and the return expectations. The higher the fee, the more return the investment needs to provide for the net performance to be attractive.

Summary

Interval funds are a new and interesting investment vehicle. But they aren't for everyone. Understanding the pitfalls is key for potential investors. If interval funds continue to attract assets, you’ll see a surge in their availability. You may find their return potentials alluring, but understanding both the pros and cons will allow you to decide whether to skip or investigate further.

Ryan Collier is the Director of Investment Management at Bedel Financial Consulting, Inc., a wealth management firm located in Indianapolis. For more information, visit their website at BedelFinancial.com or email Ryan at rcollier@bedelfinancial.com.

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