How Big Will Interval Funds Get? A Comparison to ETFs

The next wave in finance to be bigger than ETFs?

As of 2018, exchange-traded funds ("ETFs") hit a landmark as they surpassed $5 trillion in assets under management. In about 20 years, this unique investment vehicle has become one of the most popular products on the market for both institutional and retail investors. We are currently on the verge of a similar financial innovation cycle with the growth of interval funds. A look back to the history of ETFs will show that similar investment advantages and market conditions apply to interval funds today.

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Why ETFs blew up in the late ’90s

ETFs boomed in the late ’90s because they combined advantages from both open-end and closed-end funds. Unlike conventional mutual funds that only allow investors to trade once a day after markets close, ETFs are continuously traded on exchanges, like closed-end funds. But unlike a closed-end fund, ETFs can continuously offer their shares through a creation and redemption process. By combining the strengths of both types of funds without facing the problems of either, ETFs became powerful investment vehicles for asset managers.

Perhaps the strongest advantage of ETFs is that they have lower management fees than traditional mutual funds. Most ETFs track a certain index on an exchange, so they do not require active management by the fund. Furthermore, most service-related expenses, like buying and selling shares, are passed onto the brokerage firms that hold exchange-traded securities. While still providing the same benefits of portfolio diversification as a traditional mutual fund, ETFs that are passively managed offer the benefits of lower fees with greater trading flexibility.

Lastly, ETFs are more tax-efficient than traditional mutual funds. If the investor has held the ETF for more than 60 days before a dividend is issued, then it is considered a “qualified dividend” taxed at a capital gains rate, which is subject to a much lower tax rate. Although traditional mutual funds can also give out qualified dividends if they follow the same holding requirements, most actively managed mutual funds give out ordinary dividends as they receive the majority of their income from dividend-paying stocks and coupon-bearing bonds.

How are interval funds the same?

Interval funds offer similar advantages in portfolio diversification. ETFs were revolutionary because they offered low minimums with low fees to almost every asset class. Similarly, interval funds offer greater access for retail investors to pursue institutional-level investment opportunities. SEC regulations used to prevent average investors from making significant allocations in illiquid asset classes such as private loans, structured credit, or commercial real estate debt. Therefore, only institutional investors, like pension funds, could access these high-yielding assets. Interval funds overcome this institutional barrier for average investors and gives them the ability to invest in illiquid assets with extremely low minimums.

Both ETFs and interval funds are also much more tax-efficient than their traditional mutual fund and closed-end fund counterparts. Though there are some actively managed ETFs in the marketplace, most are designed to be passively managed, providing qualified dividends taxed as capital gains. Similarly, interval funds provide capital gains income as a result of longer holding periods.

Both products also offer protection against the volatility of closed-end funds. Traditionally, closed-end funds are volatile as they have a fixed amount of shares. This makes their shares prone to significant discounts whenever there is no demand for them. As a result, traditional closed-end funds are more volatile. This is one of the main reasons why investors are wary of closed-end funds despite their high yields. On the other hand, both ETFs and interval funds are continuously offered and trade at their net asset value. Even better, interval funds provide the same high yields as traditional closed-end funds without the volatility.

What makes interval funds unique?

Though ETFs and interval funds offer similar advantages, there are still significant differences between these two products. These differences are a result of the illiquid nature of the assets typically held by interval funds. Interval funds require active management as they focus on high-yield assets that aren’t correlated with the stock market. [t11] ETFs were originally designed to be passively managed by mirroring a market index, making them highly correlated to the market. As a result, key differences emerge in terms of performance and fees.

Interval funds typically have higher fees and higher yields than ETFs. ETFs can lower their administrative costs as they pass on the cost of many client-oriented services to brokerage firms, while interval funds often have higher fees associated with active management. These fees can include sales charges, operating expenses, and even performance fees.

Despite the heavier fee structures, demand for interval funds is growing because they may provide even higher yields. Due to a structure that only provides liquidity through repurchase offers, interval fund managers can invest without requiring a daily liquidity-ratio for continuous redemptions. This gives the manager the flexibility to invest larger amounts of capital into illiquid assets that have longer holding periods and higher yields. Furthermore, this gives interval funds the ability to invest in alternative, high-yield asset classes that were once exclusive to institutional investors.

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We’re watching history repeat itself

The first equity-like index funds were launched in the early 1990s. The Toronto Index Preparation units was launched in 1990 following the Toronto Stock Exchange. Though it was not yet considered a true ETF, this fund was extremely popular at the time. After three years of negotiations with the SEC, the American Stock Exchange introduced the Standard & Poor’s 500 depositary receipt (“SPDR, or “spider”), the world’s first true ETF. However, it was not until 1999 that the ETF space boomed with the launch of the Nasdaq-100 Index Trading Stock, after which ETF assets grew at an annual rate of 35.8% in the period of 2000-2005.

Interval funds are behaving similarly in their early stages of growth. Like ETFs after they became popular, interval funds grew at an annual rate of 42.9% from 2014-2018. Furthermore, in 2018, the SEC was instructed to change its rules to reduce the regulatory burden on all closed-end funds, including interval funds. Not only are interval funds growing at a fast rate, these new rules also make interval funds easier to operate and manage. While the spider had to negotiate with the SEC for three years, the SEC wants interval funds to grow faster.

Interval funds have the same advantages as the ETF to their traditional counterpart. The ETF beat out the traditional mutual fund as it offered the same options for diversification with lower minimums and fees. Similarly, interval funds are superior to the traditional closed-end fund by offering access to alternative assets for the average investor with low minimums. Though they have higher fees than ETFs, interval funds provide the same strong yields as their traditional counterpart without any of the volatility.

If the interval fund trend continues, then we are on the precipice of another financial revolution.

Photo by Anders Jildén on Unsplash