Every investor is looking for that one investment that will put them on the road to financial success and the financial markets are always coming up with new strategies to help them get there. Most of us are familiar with mutual funds, hedge funds, exchange traded funds, and traditional closed-end funds, but those aren’t the only options available to investors. One type of investment that is slowly becoming known to the investing public over the last couple of years is the interval fund. It is a closed-end fund, but it has some unique characteristics that have a lot of similarities to open end fund. This hybrid structure does much to combine the best characteristics of the open end, closed end and hedge funds. While any hybrid is by its nature a compromise, the closed end interval fund does much to get it right in answering many objections.
Flexibility and meeting market demands
The number one reason that interval funds are becoming such a popular alternative investment strategy is providing access to classes of securities previously available only to accredited and qualified investors. Many hedge fund investments are not allowed in open end retail funds because of investment strategies such as leverage, short selling or investing in illiquid securities. Some investment strategies, while allowable in an open end fund, are not ideal investments for an open end fund that must agree to meet redemptions daily.
Closed end funds deal with many of these issues, but require an initial public offering. After that initial offering is raised, adding additional investment to the fund requires an expensive secondary offering. Closed end interval funds offer new shares on a continuous basis while limiting redemptions to monthly or quarterly.
Traditional closed end funds have an additional negative: while they provide liquidity through trading on the open secondary market, market makers typically provide a bid and ask offer that is a discount from the fund’s calculated net asset value. Closed end interval funds, in contrast, issue new shares and offer to redeem shares at net asset value (NAV).
Freedom to Deal in Illiquid Assets
Interval funds may provide superior returns through the freedom to invest in alternative investments which, while limited in liquidity and possibly more volatile, have more opportunity for upside appreciation. This has made them increasingly popular among Nottingham clients. These alternative investments may include private debt securities, real estate syndications, oil and gas exploration and development funds, natural resources and commodities, and the use of leverage and short selling at levels higher than traditional mutual funds. These kinds of investments need time to achieve the returns the fund manager is looking for, which the closed end interval fund restrictions on liquidations provide. Interval funds limit liquidity to monthly or quarterly and limit the total redemptions by shareholders as a percentage of the fund.
More Accessible than Hedge Funds
Ever since private funds, or hedge funds, first hit the investment scene they have had a mixed reputation. Some of these funds have experienced spectacular gains, but others have failed in a dramatic fashion. These funds often make highly volatile and risky investments, so the potential rewards are greater, but the risks can be staggering.
Due to their volatility, hedge funds are only accessible to accredited investors with high net worth or a large annual income. They are not meant for the casual retail investor.
An interval fund may include either some of these same investments, or investments in the hedge funds themselves, but interval funds must also meet diversification requirements which limit the exposure to any one investment or class of investment.
By providing some additional investment security relative to a straight hedge fund, the close end interval fund is engineered to be less volatile and subject to single investment or single class of investment risk. In return, the closed end interval fund is available to a more retail audience.
Not Your Typical Closed-end Fund
One of the main characteristics of a closed-end fund is that it has a set number of shares that are offered in an initial public offering. This is one of the features that attracted me to it. After that those shares are then available for trade on the market just like standard stocks. Their share price can fluctuate throughout the trading day. Market makers typically insulate themselves from this risk by offering the shares at a bid and ask price that is below the calculated net asset value.
An interval fund, on the other hand, is not traded on the secondary markets. Shares must be obtained directly from the fund itself and their value is always based on the net asset value of their portfolio. The fact that they can’t be redeemed daily like an open end fund means the fund manager has the security to invest in less liquid assets that offer higher returns. This is not possible with a closed-end fund.
A Little Research Goes a Long Way
One caveat and item to consider is fees. The investment management fee associated with interval funds is typically higher than most open end mutual funds. It is always a good idea to review and understand all the fees involved in any fund before buying into one.
About the Author
Frank “Kip” Meadows is the Chief Executive, chief consultant and founder of Nottingham in Rocky Mount, North Carolina. Nottingham clients include mutual funds, private funds and other pooled investment vehicles including, foundations, endowments, and government investment pools.