At HH, we understand the confusion that investors can face when considering not just the merits of an investment, but also its structure – particularly when that structure departs from the everyday world of common stocks and plain-vanilla bonds. Within the structure lies the details – and we all know who resides in the details.
The point of this blog is to focus on a single product type within the world of managed investments: what’s commonly referred to as an “Interval Fund.”
But first, a brief overview of what I mean by “structure.” When investors look to put their money to work, they have a litany of options. For instance, they can buy a basket of investments through a mutual fund, a closed-end fund, or an exchange-traded fund (ETF). They can buy public or private businesses directly (if they have connections) or they can rely on third-party firms to provide that access through limited partnerships or limited liability structures – what are often colloquially referred to as “hedge funds.”
If there’s one thing we can all agree on, it’s that Wall Street is good at creating ways they can make money for themselves, structuring (and restructuring) the various ways investors can invest. But product structure regulations designed through legislation such as the 1940 Investment Company Act exist for a reason: to protect both issuers and investors. Interval funds are a great example.
Interval Funds: Entrances and exits are limited – for a reason
An interval fund is a closed-end mutual fund, registered under the aforementioned Investment Company Act of 1940. Like all mutual or exchange-traded funds, the structure is fully transparent with audited financials and regulated disclosures. But unlike open-end mutual funds that are bought and sold at the Net Asset Value at the end of each day, and unlike ETFs that can be bought and sold at the current market price throughout the day, interval funds have specific time frames when investors can purchase and sell shares of the fund.
Interval funds offer to repurchase maximum amounts of the fund, say 5%, 10% or 25%, at regular increments of time; usually, but not always, on a quarterly basis. It’s important to note that these repurchase limits are established by the funds’ boards of directors and are not a matter of discretion for the manager. If redemption requests exceed these thresholds, the manager will limit redemptions by “gating” the fund to allow for orderly liquidation. This means that the fund will limit redemption requests by pro-rating said requests.
For instance, if the gate limit is 10%, and investors in the fund are looking to redeem a total of 20% of its asset value, the fund will provide 50% liquidity to all those who request it. If, under the same redemption request, the gate limit is 15%, all investors would be able to redeem 75% of the value they’ve requested.
Matching a fund’s liquidity to its underlying investment liquidity
This begs the question: Why would someone be willing to reduce the flexibility and regularity under which they could sell their investments? Let’s start by considering this: If the underlying investment within the product trades daily and has ample liquidity, then reducing liquidity at the product level is inappropriate and unnecessary. But if the underlying investment has unique risk characteristics, trades on a bespoke basis between counterparties, or provides access to a risk-and-return stream not readily available in traditional asset classes, then matching product liquidity to underlying investment liquidity is a must.
Here’s a quick real-life example: In 2015 there were concerns about the economy and company indebtedness. A growing swell of risk aversion started a junk-bond selloff and spooked investors across the high-yield credit market. One fund run by Third Avenue, the Focused Credit Fund, received significant redemption requests and was forced to sell its suddenly illiquid, poorly trading bonds. This additional selling pressure and illiquidity begat further concerns and prompted increased requests for redemptions. A vicious cycle to be sure.
This supposedly “liquid” fund’s underlying asset illiquidity would not allow the fund to meet its requested redemptions. The Focused Credit Fund had to close, lest it be subject to pennies-on-the-dollar fire-sale prices. The fund’s managers were required to move their clients’ money into a liquidation trust, thereby restricting its availability for the next few years. Bottom line, the fund’s panicked sellers caused irreparable damage to its more patient, long-term-oriented holders.
The interval fund structure is designed to reduce the impact of forced redemptions from such transient investors. Assuming a compelling investment thesis remains, or perhaps has even improved following a period of average-investor panic, the interval fund structure helps protect existing shareholders. And it protects the fund’s manager from being forced into untenable liquidation requests. In other words, this structure is designed to reduce a potential misalignment of product liquidity and underlying investment liquidity.
Helping to reduce the hegemony of (expensive!) hedge funds
The reality is that many unique investment concepts have traditionally been the domain of hedge funds. Available only to the “qualified investor” and through opaque limited-partnership structures, hedge fund investors were often saddled with exorbitant management and performance fees as well as reduced liquidity. For investors willing to pay a 2% management fee, a 20% performance fee and deal with the inefficiency of K1 tax returns and a lack of liquidity, hedge funds may (still) have been reasonable investments.
But for the traditional investor looking to access the unique risk-and-return potential of non-traditional assets, interval funds can now provide a transparent, lower-cost, middle-ground gateway to these opportunities. Sure, investors may give up some flexibility, but they typically do so for their own benefit.
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The views contained herein are not to be taken as an advice or recommendation to buy or sell any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without previous notice. This material should not be relied upon by you in evaluating the merits of investing in any securities or products mentioned herein. In addition, the Investor should make an independent assessment of the legal, regulatory, tax, credit, and accounting and determine, together with their own professional advisers if any of the investments mentioned herein are suitable to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment.