Interval Funds
Nov 03. 12:02
Diversifying with Alternative Assets
Diversification: What, How, and Why?
For the past 70 years, Harry Markowitz’s “Modern Portfolio Theory (MPT)” has shaped investments and personal finance. The theory basically states that every investment is an exposure to a set of risks, and that at every risk level there is an efficient portfolio that maximizes your expected return. An investor could be interested in high returns and will subsequently accept more risk for those returns. Conversely, they may want to opt for consistent, low-risk income.
Regardless of an investor’s goals, portfolios must incorporate a broad range of investments to be efficient. An efficient portfolio incorporates different amounts of public securities – cash, equities and bonds – as well as private and alternative investments that aren’t correlated to the public securities. In this way, any single underperforming asset class won’t drag down the investor’s whole portfolio. An efficient portfolio should also encompass a range of passive and active investments: passive equities and bonds with zero-to-low fees that follow the broader market, and active investments with managers picking themes and sectors. Active investments should offer yields and returns that outperform the market in exchange for a fee.
What are common types of alternative investments and some of their drawbacks?
Alternative investments are not meant to replace your portfolio; they are there to complement and balance it. Alternatives may have a low correlation with the rest of a portfolio, meaning that they can give a positive return even when markets are in a downturn. Not all alternative investments are created equal; investors can treat the diverse $10 trillion universe of alternatives in different ways. For example, they can provide a greater return than public markets, reduce tax exposure, limit risks from volatile currency exchange, and produce higher returns in low interest rate environments.
When investors consider alternative investments, they traditionally think of hedge funds, private capital (equity and credit), real estate, and venture capital. These asset classes are generally actively managed; there are individuals making decisions on how and where to invest, and these investors expect higher returns for the risk those decisions present. In the past decade, hedge funds and their high fees have on average underperformed the relatively stable public markets, as this asset class generally only thrives during volatile times or when market information is not public. Private capital does not [RM6] generally fare better, on average private capital has underperformed public markets. Real estate funds invest in pools of different properties and can trade on the market, and although they have provided stable returns, investors must pay extra performance and management fees for consistently good returns, and these fees generally increase with fund performance. Venture capital returns have been hit-or-miss, with only 5% of firms exceeding 20% annualized returns, and the top quarter of firms contributing the greatest share of returns for investors, but these firms charge inexplicably high fees for a smaller and smaller universe of potential deals. Additionally, most of these alternatives are completely illiquid; they block investors from withdrawing money entirely with a lock-in period and do not compensate for this illiquidity with higher returns.
Considering these drawbacks, an investor would be wise to ask: why include alternatives at all in a portfolio? Again, the answer is diversification. For example, a hedge fund might underperform in a stable market, but during crisis periods the top performers could return in excess of 100%. In periods of low inflation and slow growth like the one we are currently in, investment managers with active strategies should provide higher returns that provide long-term growth of the investor’s portfolio. For investors close to retirement, the returns of riskier assets like venture capital may be enticing, but they need to ask themselves if that risk is acceptable. An investor close to (or in) retirement has different needs than a younger investor just starting to save. Older investors need stable returns during both market booms and busts, and they need to select alternative investments that provide that safety and surety.
What are Interval Funds, and why include them in an alternatives strategy?
Investors buy actively managed and alternative assets for the higher returns and diversified strategies they promise, but they pay for this promise with higher fees and illiquidity. A US investor looking at making an investment into an actively managed mutual fund has 9,599 funds to choose from. An investor who is looking to make a long-term investment and is comfortable trusting a manager to pick active investments should consider the smaller universe of interval funds as part of their alternatives strategy, as they offer the optimal mix of periodic liquidity, uncorrelated returns, and a tangible liquidity premium, whilst still protecting the investor with a structured repurchase offer.
At their core, interval funds are a type of closed-end mutual fund, meaning that they raise a certain amount of funds and entrust a manager to invest those funds as they see fit. Interval funds are not publicly traded on secondary markets. Interval funds allow investors to redeem parts of their investment only at certain times each year, which gives the manager the freedom to invest in illiquid assets like commercial real estate, or assets with longer holding periods like private loans and structured credit. Where the Investment Company Act of 1940 limits mutual funds and open-end funds to investing a maximum of 15% into illiquid assets, interval funds provide average access to a diversified portfolio of these securities. These funds tend to charge higher fees than other closed-end funds; however, they provide higher and consistent returns as a result of the manager being able to make longer-term investments.
How much of a portfolio to invest in Interval Funds?
Depending on an investor’s risk tolerance, investment managers recommend that up to 20% of a portfolio should be allocated to alternatives and that investors should split this between multiple strategies for maximum diversification. Whatever percentage an investor is comfortable with, they need to make sure to allocate enough to have an impact on the overall portfolio. Small allocations will have a negligible impact on the portfolio, which would defeat the purpose of adding alternatives in the first place.
Investors looking for long-term diversified returns should include interval funds in their portfolio. Investors should be comfortable with their principal being unavailable for a long timeframe and understand that like all alternatives, managers charge fees to access the higher returns associated with interval funds.